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The Best Way to Play the Coming Crude Oil Rebound

Commodities / Oil Companies Apr 27, 2009 - 08:41 AM GMT

By: Investment_U


Best Financial Markets Analysis ArticleDavid Fessler writes: Crude oil is at a one month low, and lately it’s done nothing but drift lower and lower.

Sadly, that’s about to change.

It might seem counter to what the markets are telling us right now. Because the lack of global demand and strengthening U.S. dollar - that oil is priced in - are keeping prices depressed.

There seems to be no reason why oil prices should do anything but flat-line for the next few months. And it’s why most have missed the signs.

And if you’re hoping for a similar drop in gasoline, forget it. The summer driving season is just around the corner, and gasoline prices will likely rise (as they nearly always do) ahead of it.

The small increase in summer driving demand aside, the stage is currently being set for oil prices to skyrocket, even as global demand continues to weaken.

OPEC Can’t Cut Fast Enough… or Deep Enough

First, our good friends at OPEC - and I use that term loosely - decided to cut the supply, shutting the spigot on 4.2 million barrels since last September. This is equivalent to roughly 5% of the world’s supply.

According to Mohammed-Ali Khatibi, OPEC may agree to even more cuts when it meets on May 28, if - in its view - the market continues to remain over-supplied. The OPEC ministers feel some countries are actually hoarding oil.

Why would countries hoard oil? One reason: they feel that prices are going to go much, much higher. China is quietly buying oil from Oman - 12.7 million barrels in January and February alone - more than any other country.

The United States is getting in the act, too. According to the U.S. Department of Energy’s website, the federal government is quietly topping off the strategic petroleum reserve, pumping in 17.2 million barrels since the beginning of 2009.

This gesture is more symbolic than anything else, since the 727 million barrel capacity represents a mere 62 days of protection from having to import oil. The thing that’s most interesting about this activity is that the reserve now holds the highest level of inventory in its history, 717.2 million barrels as of April 21.

Bottom line here is that even with OPEC cutting supply, demand is dropping even faster, as the global economy is in stall mode. The strong dollar is just an additional weight on prices.

Supplies Are Drying Up… or Are Simply Not Being Pumped

Second - and this has been reported ad nauseum in the press for the last several years, but it bears repeating - mature fields are declining in output.

Mexico’s Cantarell Field is probably experiencing the most dramatic decline. As a result, Mexico is probably in its last year of exports. Saudi Arabia’s Ghawar Field - the largest oil field in the world - is also near the end of its life.

The Canadian Athabasca oil sands - environmentalists refer to it as the world’s dirtiest oil - is an environmental disaster in the making. Deposits are still being mined, but only at minium rates in existing fields due low oil prices. Nearly $100 billion in expansion projects are currently on hold.

And the big Tupi field off the coast of Brazil? Retrieving this oil from six or seven miles down makes no economic sense unless oil is over $90 to $100 a barrel.

New Exploration and Drilling? Not Now

Two years ago, drilling stocks like Apache Corporation (NYSE: APA) and TransOcean, LTD (NYSE: RIG) were all the rage - and for good reason.

When oil was at $147 a barrel, they couldn’t make their day rates high enough to quench the seemingly insatiable drilling demand from oil companies. Rig drilling contracts and new rig orders were backlogged for years. Then the bottom fell out.

New drilling and exploration ground to a halt - to date, nothing’s changed.

The result is the reserve to production ratio - a measure of the world’s ability to maintain current production - which has been relatively stable for the last 10 years - will start to decline in the absence of any new exploration.

Taken together, all these events and scenarios are combining into a perfect setup for higher prices that most analysts have failed to comprehend.

And when the scramble to increase production in response to skyrocketing demand increases - just like it did several years ago - the increase in crude prices will be far more dramatic than it was in 2007 to 2008:

  • There will be less overall supply able to come on-line quickly.
  • Few new fields will be available to tap, and those that are will take years to ramp up to meaningful capacity.
  • New exploration will have to restart from scratch.
  • Tar sands expansion will take four to five years to bring on-line.
  • China and India are quietly signing contracts for many of the world’s excess reserves, further limiting U.S. options.

The bottom line is that the very companies that are today’s losers will likely be big winners as demand returns. We’ll be watching for specific opportunities.

If you decide you must get in early, easing your way into a position in the PowerShares DB Crude Oil Double Long ETN (NYSE: DXO). Trading down nearly 90% from its one-year high, DXO could be just the ticket to stellar returns down the road.

Expect some volatility in the short term, as oil prices will likely bounce along in a narrow range for the next six to 12 months before heading higher.

Good investing,

David Fessler, Advisory Panelist

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