Thoughts on The Price of Oil and Long Term Investing

Note: updates at the bottom.

Introduction

This is idle chatter, one might hear over the coffee table at the Economart in Williston. Consider it nothing more than idle chatter, but something I want to throw out there for others to comment on. I'm trying to make sense of the price of oil at $70 per barrel and the price of gold hitting a new high, solidly over $1,300 per ounce.

First, of all, I'm an optimist.

Second, I'm bullish on oil as an investment.

Third, I'm inappropriately exuberant about the Bakken.

Fourth, I do not have formal training in business and am very naive in all areas of finance.

Part The First

For years, it was my understanding that because oil and gold were both commodities, it was not unusual for the two of them to be priced relative to the dollar. As the dollar went down in value, the price of commodities went up (all things being equal). Of course, "all things being equal," is critical. During perceived shortages (the Hunt brothers' attempt to corner the silver market; the OPEC embargo; etc), supply and demand had a greater impact than the value of the dollar.

For years, it was my understanding that investing in commodities, such as gold and oil, were used as a hedge against inflation. 

But, recently, it appears the price of gold and the price of oil have diverged. The general consensus that in the short term deflation is a greater concern than inflation, and thus the ballistic rise in the price of gold is not due to worries about inflation. If gold prices were a reflection of worries about inflation, then one might argue that one should see a similar rise in the price of oil.

So, for reasons other than worries about inflation, the price of gold is rising very quickly. The news that governments have clamped down on domestic banks from divesting themselves of gold will only exacerbate the situation. So, repeating, for reasons other than worries about inflation, the price of gold is rising very quickly.

On the other hand, whatever is causing investors worries, it is not the kind of worry that prompts investors to push the price of oil up in a similar ballistic manner.

I am going to posit that the reason that gold is rising quickly is because there is a perceived shortage of gold as the "gold" standard (no pun intended) for safety. It almost seems like a bunker mentality. Fearing the absolute worse, default of one's government/country (Portugal, Ireland, Italy, Greece, Spain, e.g.), folks are buying gold. I don't know how much gold is out there. But first there is a rush to safety, and as that is bought up, there is a perceived shortage. One sees the same thing with bottled water in the face of an impending hurricane. First, there is a rush to buy it, and then as the bottles come off the shelves, there is a perceived shortage (despite the fact Wal-Mart one state over has trucks of bottled water).

So, let's assume that's were we are now. There was a rush to safety, the initial buying of gold when it went through the $800 $1,200 range. Now there is a perceived shortage and that will take the price of gold to yet new highs, today solidly over $1,300.

Now to the price of oil. 

Part The Second

Now, to the price of oil. People flock to gold for safety. They don't flock to oil for safety.

If there is a perception that their governments could default, or that the global economy could go into a depression, folks want gold, not oil.

However, let's say a couple of years go by, and somehow there are no major national defaults, somehow the PIIGS get through this. Let's further imagine that a couple years from now, the global economy has recovered, and there is no longer any threat of another recession, much less a depression.

If the global economy gets back on track, the requirement for energy will increase. I don't think anyone will argue with that.

Now look at the graph I linked a couple of days ago at The Oil Drum/Europe.

Look at the tremendous spike in the price of oil a couple of years ago. Pretty spectacular, isn't it? Now look at the total amount of oil production through all of this. It remained unchanged, give or take a bit of background noise, which I doubt was statistically significant.

Now look at a graph of energy consumption. I apologize for this. It's a PDF and will take time to download, but click on the link: Shale Gas Revolution, International Study/UK, 2010, a "Chatham House Report." As noted, this study was done in Britain, and is very, very up-to-date.  When you get to that PDF, go to page 14 of 46 (or page 5 of chapter 1) and take a look at Figure 3: UK Primary Energy Consumption by Fuel, 1965 - 2009.

Figure 3, referenced: This is not ancient history. One could argue that China, today, is where Britain was in 1965. Back in 1965, the UK used "no" natural gas, but as the use of coal decreased, natural gas stepped in to make up the difference. The amount of oil consumed did not change much except for short periods. We can ignore nuclear energy for now.

We now have two graphs, one from The Oil Drum and one from the Chatham House Report. They seem to support each other. In one case, we see that despite the spike in the price of oil, world production did not increase. And in the other report, despite the price of oil, the amount of oil used in the UK did not appreciably change, at least not enough to show up on this graph.

I am not a "believer" in "peak theory of oil" as it is currently posited, but I do think that there is very little slack in available oil as measured in one to two years. If one could predict that "$150 oil" was going to be here starting January 17, 2015 and never retreat, I feel strongly that the oil industry would respond, but the lead time is horrendous, not just for the drilling, but for the infrastructure (pipelines, and tankers). Now, add in environmental controls, and the lead time is even greater.

My hunch is that it's just a matter of time when we see the price of oil do what we're seeing with the price of gold.

Instead of a flight to safety, there will be a real need for increased energy. Look at that UK graph. The population of Great Britain is 61 million; the population of China is 1.3 billion (20 times greater); and, the population of India is 1.1 billion.  We can ignore solar, wind, and nuclear power, Coal will remain important. But the need for natural gas will increase exponentially, and the need for oil, likewise.

But that's not to say that the industry will respond.

Part The Third

If given enough time, I think the industry could respond, but the lag time will be measured in two to five years. It's possible the increase will be so severe a reactionary recession or depression could occur, but the point is that when the global economy recovers, there will be a flight to fossil fuels. Like the early phase in the price of gold going through $800, there will be an orderly (or disorderly) rise in the price of oil.

When it is realized that the graph in The Oil Drum is the way it is because the totality of oil reserves is pretty much tapped out, there will be a perceived shortage, just as there is a perceived shortage of gold, pushing the price of gold solidly over $1,300.

Drillers can only drill so fast. Just like the "flash crash" of the stock market on May 6, 2010, which no one can explain, no one has been able to explain the $150 spike in the price of oil. Relative to the long history of oil production, the spike to $150 dropped back as quickly as it rose. No one has offered a good explanation.

For those who are fleeing to safety in the current economy, they are buying gold; for those perceiving a shortage of gold, they are willing to pay $1,300 per ounce.

Part the Fourth

Why aren't investors fleeing to oil for safety, as they were fleeing to safety (when gold was $800 - $1,200).

Gold and oil are inherently different. At $1,300/ounce it doesn't take much room to store it. Gold is not used up (except for jewelry and some high tech requirements, but people aren't buying gold to turn it into something else).

The only value oil has is when it is turned into energy.

So, for all practical purposes, an investor, or the average person, cannot buy oil, whereas an average person can buy gold, very easily and hold it forever.

Part the Fifth

So, what is one to do, if one is an optimist, one is bullish on oil, and one is inappropriately exuberant about the Bakken?

Certainly one cannot buy Bakken oil and store it in the garage.

But one can do the next best thing: buy Bakken oil and store it in the ground. And, the best way to do that, is to buy (or accumulate) Bakken acreage. And the best way to do that, for the average retail investor, is to buy (or accumulate) shares in companies (generally oil companies) that are buying up acreage in the Bakken.

All things being equal, I don't think it matters a whole lot whether one buys shares in Continental Resources, Brigham Exploration, Whiting, Kodiak, Oasis, EOG, Hess or a whole host of others in the Bakken. Some will end up being better than the others, and more about that later, but right now, pick your favorite for whatever reason, and start accumulating shares (acreage).

Acreage was being sold for $500/acre less than a few years ago, and there are still acres in some areas of the Bakken that are going for that amount. But, the state of North Dakota sold leases for $12,000/acre in a small area in a recent sale. Within the last two weeks, Enerplus agreed to purchase acreage for an average price of almost $10,000/acre.

In the near term, the amount one is willing to pay for an acre in the Bakken will top out, but once the global economy turns, and there is a perceived shortage of oil (real or not), the price of oil will take off.

As I said earlier, all things being equal, I don't think it matters a whole lot what Bakken driller you decide to invest in. However, if one has to separate it out, I would look at those companies whose stated strategic vision is to accumulate acreage, not just develop what they have.

Some of the acreage that is accumulated will be "outside the core area" as currently defined. But before 2000, none of the Bakken was worth going after. The drillers seem to be getting better at getting oil out of the ground "outside of the core area." If one thinks technology and processes will improve over time, then accumulating acreage outside the core area is a good strategy. Look at the Investopedia article today about drillers going into Montana, clearly "outside the core area" as currently defined by some (not me).A musical interlude: My Wife Thinks You're Dead, Junior Brown

Summary

Bottom line: I think at some point there will be a perception that there is a shortage of oil (real or not), and that will result in a spike in oil prices. There will be a tipping point, but once it occurs, the increase in price will come quickly (we've seen it once). First, people will start fleeing to oil (and natural gas) because they need it, and once they start fleeing to oil (and natural gas) because of a perceived shortage, the spike will be remarkable.

Holding Bakken acreage, any Bakken acreage, will be like holding gold.

I'm sure my argument is weak in many, many places, but remember, I'm an optimist, a bull on oil, and inappropriately exuberant about the Bakken. The latter has not disappointed me yet.

Again: This is idle chatter, something one might hear over the coffee table at the Economart in Williston. Consider it nothing more than idle chatter, but something I've been thinking about, trying to figure out why the price of gold and oil have diverged.

*****

Updates

October 3, 2010: What Crude Prices Are Telling Us, Seeking Alpha.

October 2, 2010: The (London) Independent, "The Chinese Land Grab."

October 1, 2010: Jim Cramer, CNBC, said price of gold is going up due to increased demand by BRIC citizens (Brazil, Russia, India, China). He says "increased demand"; I say "perceived shortage."