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On Oil and Natural Gas

In many previous articles, I have talked about the negative consequences of Federal Reserve policy and the seemingly imminent threat of inflation.

In this article, I'd like to talk about something positive: how to make money from what's happening in financial markets.

In the world economy, competition for labor and resources is heating up. So far, this competition has been most evident in the price of oil - in large part because oil is so easily transportable and because it is so important to every economy. Oil is not only important for transportation but also for the manufacturing of petrochemicals, which are used for so many purposes.

However, with oil prices having risen from $12 in the late 90s to around $85 today, it is fair to ask: is this just another bubble waiting to pop?

In investing, my preference is always to ignore the "psychology" of the market, to try to understand the fundamentals, and then to set a long-term horizon for my investments (by not being leveraged or overcommitted in any way - in case my trades move against me even as the fundamentals stay in my favor). I believe that over the long term markets are rational (even though they can be highly irrational in the short run, cough, pets.com).

So, what are the fundamentals for oil and natural gas?

Today, according to the International Energy Agency ("IEA"), oil consumption is currently slightly ahead of production. IEA figures estimate demand at 85.9 million barrels a day ("mb/d") and production at 84.6 mb/d.

Despite alternative sources of energy and energy efficiency initiatives, demand for oil has grown tremendously over the last 30 years. In 1980, demand for oil was a little over 60 mb/d. After the 1981 recession, demand sunk just below 60 mb/d, but has since climbed to over 85 mb/d. With emerging economies growing quickly, demand is estimated to continue to grow. According to the U.S. Department of Energy, worldwide production is expected to increase to 98 mb/d by 2015 and 118 mb/d by 2030.

Growth in oil consumption is being driven by strong demand from Latin America, the Middle East & Africa, and Asia. In the early 80s, Latin America consumed around 3 mb/d. Today they are consuming over 5 mb/d. In the early 80s, the Middle East & Africa consumed around 3.5 mb/d. Today they are consuming around 9 mb/d. In the early 80s, Asia consumed around 9 mb/d. Today they are consuming over 18 mb/d.

India's demand alone has grown from under 1 mb/d in the 80s to nearly 3 mb/d today. China's demand has gone from around 1.5 mb/d in the early 90s to around 6 mb/d today. No wonder the U.S. Energy Information Administration expects China's demand to triple by 2030. India and China have over 2 billion citizens combined, versus 300 million for the U.S., yet their combined oil consumption is around 9 mb/d vs 21 mb/d for the U.S.

Another factor driving consumption growth is central bank policy. Money supply worldwide is growing extremely quickly, meaning more consumers have more money to spend, even in spite of higher oil prices. Until central banks launch a serious campaign to raise worldwide interest rates and reduce aggregate demand, oil consumption growth should continue at a rapid pace. Money supply in China is growing around 15% a year. The same is true in India. Even M3 in Europe is growing around 10% a year, and reconstructed M3 in the U.S. is likely growing by similar amounts. Oil-rich countries in the Middle East are experiencing even faster money supply growth.

Although some central banks are starting to show slight concern about inflation, few of them have taken serious steps to reduce their money supply. In the 1970s, it took nearly a decade of inflation for the U.S. Federal Reserve to become serious about fighting inflation. Many pundits and economists expressed surprise at the cause of inflation, despite the conclusion by Milton Friedman that: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output."

Despite the rapid growth of money supply worldwide, central bankers are hesitant to take the tough and unpopular step of raising interest rates, as evidenced by Bernanke's testimony last week. Ron Paul was lambasting Bernanke, claiming a weak dollar would lead to more imbalances and difficult times. Bernanke essentially responded that as long as core inflation remained contained, a weaker dollar was not a problem. The implication: even if oil prices are high, the Fed will keep interest rates low. Only if workers start demanding higher wages in the U.S. will the Fed take any action.

Although the supply of new oil has just managed to keep up with consumption, excess capacity has fallen. Oil production is very difficult. There are often outages, due to storms, due to technical problems, such as pipeline or refinery issues, and due to political conflicts. Outages are normal for the oil industry and lead to quick, large, yet temporary spikes in price. Because it is known that outages occur so often, the oil industry relies on excess capacity, which is production that can be brought online quickly but which is not currently producing.

During the oil embargo of 1973, excess capacity shrunk to 3 mb/d. During the Iranian revolution of 1979, excess capacity was down to 4 mb/d. During the 1980s, excess capacity climbed up to nearly 11 mb/d. Where is it today? It is estimated to have sunk to around 1 mb/d a couple of years ago, and to be around a little under 3 mb/d today. Given the growth in consumption from 60 mb/d to 85 mb/d, excess capacity is extremely low, even as China, India and others consume more and more. If a political event disrupts the flow of oil now, there is hardly any cushion.

Oil rigs are used to drill for more oil and establish new, producing wells. Rigs counts went from 2,000 in the early 70s to over 6,000 in the late 70s. Following the oil bust of the early 80s, rig counts declined to nearly 1,000 by the late 90s. With the rise in consumption, rig counts have since climbed back to 3,000, but with production declining in many major oil fields around the world (the North Sea, Mexico, and even Saudi Arabia according to some estimates), rig counts may need to go even higher to meet growing demand.

Meanwhile, natural gas prices have diverged significantly from the price of oil. Historically, the price of oil has averaged around 6.2 times the price of natural gas. In other words, if oil is $80 a barrel, natural gas would normally trade at $12.90 per mmcf. Why? Because there is an energy equivalency of 6.2 times between a barrel of oil and a mmcf of natural gas. However, natural gas is not $12.90 per mmcf. Rather it ranges from $6.30 for the forward month contract up to $9.12 for natural gas delivered in the winter of 2009. In other words, natural gas is extremely inexpensive relative to oil by historical standards.

Why? For starters, natural gas is not as easily transporable as oil. Therefore, its price is driven by supply and demand in regional markets. Since Hurricane Katrina, there have been no major outages of natural gas supply in the U.S., there has been increased production (as a result of the high prices after Katrina), and the summer and winters have been mild, resulting in reduced consumption. As a result, natural gas inventory levels are about 13% above their historical averages. If natural gas exceeds storage capacity, producers have no other option than to burn the natural gas. These burn-offs are extremely costly and wasteful.

While the threat of burn-offs is real, especially if this winter is mild, for long term investors natural gas represents a great value. Natural gas is domestically produced in large quantities and doesn't have to be shipped from the Middle East, Venezuela, Nigerian, and other politically sensitive parts of the world. It burns more cleanly than oil and therefore is better for the environment. And now it is significantly less expensive. That's why industry tycoons like T. Boone Pickens have started companies like Clean Energy Fuels, which is producing natural gas to be used to power buses and cars. It may take a long time, but eventually more natural gas and less oil will be used in the United States, until the price ratios come back to around 6.2.

So how can we make money given what is outlined above?

My idea has been to invest mostly in domestic oil and gas producers. They are U.S. companies, with all the transparency and legal protection that comes from owning U.S. companies. Many also have debt in U.S. dollars, which benefits as the dollar falls and oil prices go up.

My favorite stock is Devon Energy (symbol DVN). DVN has first rate management that understands the financial and macro elements of the oil and gas industry, but they are also showing how effectively they can manage their assets by growing production through the drill bit. Production at DVN is increasing around 10% a year, which produces excellent results in times of rising prices. They also get about 60% of their production from natural gas, which means they can benefit if natural gas prices return to their historical ratio with oil. DVN also does a great job of managing their risk. Most of their assets are in steadily producing wells, while a small portion of their assets is in high-risk exploration. DVN recently was upgraded by Moody's because of improvements in the company's leverage and production.

Another company I have bought is Compton Petroleum (symbol CMZ). They have not done well with what has happened to the price of natural gas. CMZ is a Canadian natural gas producer. They have grown their company in a fast, strategic manner. They want to continue to grow in a way where they can manage costs and leverage the development of their highly-effective, efficient production team. While natural gas has performed worse than oil, especially in Canada, I believe this company will do well over the long term, whenever natural gas prices rebound. The only downside is that they are Canadian (no offense to our Canadian brethren, but Canadian companies can oftentimes be less investor friendly and subject to a government that is less business-oriented).

Another company I am considering buying is EOG Resources (symbol EOG). EOG is very conservative and smart. They are not leveraging their company, leaving their options open. They have proven themselves to be very effective in terms of increasing production organically (without acquisitions). Currently they are increasing production by 10 to 12 percent a year. As a conservative, domestic producer with exposure to natural gas, they are well positioned should natural gas prices rise.

I also own Exxon (symbol XOM) because of how well managed they are, and how diligent they are about using their capital only in projects that have compelling returns.

I recently add ConocoPhillips (symbol COP) because of their valuable refining assets, their investment in Lukoil, and because the company seems to be taking steps to restructure and improve their operations. COP has traded at a discount to other majors over the last several years, but their restructuring efforts may provide an extra boost soon.

Another new favorite is InterOil Corporation (symbol IOC). IOC is engaged in the exploration of natural gas and oil in Papua New Guinea. The company is a fully integrated, with upstream, midstream, and downstream assets. Exports should benefit from Asia's growing appetite for oil and gas. Of note, T. Boone Pickens recently made a large investment in the company.

Why isn't Clean Energy (symbol CLNE) on the list? Valuation. If it comes down in price dramatically, I'll definitely add some. I think Pickens is a genius, and I love the idea of using natural gas to power buses and cars. Even with CLNE's growth prospects, though, it seems overvalued.

Other oil and natural gas companies aren't as highly priced as CLNE, but they aren't exactly cheap. By historical standards, oil and natural gas companies are highly valued relative to their book values. However, given the irresponsible actions of the worlds' central bankers, the increasing demand/supply imbalance in oil, and the divergence in the price of natural gas, I will continue to buy high quality oil and gas companies on dips in their stock prices. I'm not buying today, but if prices pull back 10% or so, I'll start adding more to my already significant positions.


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