Stocks That Will Rise with Oil Prices

03/16/2010 10:26 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Those predictions of $200 oil you heard a couple of years ago may not have been as wrong as they were premature. Plus: A Jubak's Picks progress report.

Whatever happened to $200-a-barrel oil?

Maybe it's just been delayed in transit. A recession in the world's developed economies can do that.

Remember Arjun Murti's time in the sun when, in May 2008, the analyst at Goldman Sachs predicted that oil would soon hit $200 a barrel? A number of other prognosticators weren't far behind. T. Boone Pickens predicted in 2008 that oil would hit $150 by the end of the year. Some guy named Jim Jubak in April 2008 called for $180 a barrel within two years.

In case you haven't noticed, all of us were wrong. Oil peaked at $147 a barrel in summer 2008 and then plunged to $35 a barrel by June 2009.

Let me rephrase that: We weren't wrong; we were early. (All financial fortunetellers are told over and over again in their training at the Frogwarts School for Financial Wizards that you never, never, never forecast both a price and a date. One or the other. Never both.)

A little thing called the Great Recession killed global demand for oil. For a while.

A Prediction Delayed, Not Changed

But none of the supply-side problems that led me and others to predict $150-to-$200 oil has gone away. As soon as oil demand rebounds with a global economic recovery, I think we're going to be right back on the road to $150-, $180-, or $200-a-barrel oil.

There are global trends that could scupper that prediction, too, but I don't think those forces are moving fast enough to change the price trend over the next ten years or so. (But I will outline those countervailing trends later in this column.)

The global recession wiped out roughly two years of worldwide demand for oil.

In April 2008, the International Energy Agency (IEA) was predicting that global demand would hit 87.2 million barrels a day in 2008. That would have been an increase of 1.3 million barrels a day from the 85.9 million barrels a day in global demand for 2007.

By spring 2008, the IEA already saw a slowdown in the US economy, but didn't think it would significantly depress global oil demand that year.
The slowdown, however, turned out not to be limited to the United States, and in developed economies, it hit hard enough to earn comparisons to the Great Depression.

Global oil demand fell to 85 million barrels a day in 2009, down 1.4% from 2008, and lower than in 2007. As of March 12, the IEA was forecasting that global demand will climb to 86.5 million barrels a day by the end of 2010. That would mark a total increase in global demand of 0.7% from 2007.

Before the fall and then stagnation in global demand for oil, the IEA was worried that global investment in finding oil, developing those finds, and increasing production from existing fields wouldn't keep up with global demand and would send oil prices surging. The three examples that I cited in my column were Russia, where the oil ministry was predicting a decline in production for 2008; Nigeria, where massive corruption left the country's plans to double oil production laughably underfunded; and Mexico, where underinvestment in oil fields, including the huge Cantarell oil field in the Gulf of Mexico, had already resulted in an 18% decline in production in 2007.

Fast forward to 2010: The IEA is worried about, you guessed it, underinvestment on finding oil and developing reserves. Global capital spending on those activities—including spending on maintaining or increasing production from existing fields—fell $90 billion, or 19%, in 2009. That decline, the IEA reports, was the first in a decade.

Three trends make this decline particularly troubling to the IEA.

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First, the world's most deep-pocketed oil companies, the Western oil majors, are increasingly excluded from the most promising areas for exploration and development. National oil companies control access to those geologies, but often don't have the capital to exploit them fully because national governments siphon off oil revenues to fund government budgets.

Second, the cost of finding oil continues to rise. Western oil majors have recently reported a rise in the drilling failure rate. Chevron (NYSE: CVX), for example, reported that 35% of the wells it drilled in 2009 came up dry. In 2008, the rate was just 10%. More dry holes mean spending more money to find less oil. (For more on the dry hole surge, see this post on my blog.) And more of the wells that actually find oil are in extremely challenging geologies. On March 11, for example, BP (NYSE: BP) paid Devon Energy (NYSE: DVN) $7 billion for assets that included Devon's stake in the promising Campos deep-ocean region off Brazil. The oil and gas in this region are under more than a mile of water and a thick layer of salt. Drilling a single well could easily cost $100 million. Energy analysts estimate that BP needs a price of $70 a barrel or more to break even on the assets it purchased from Devon. If break-even on new oil is $70, that would suggest that oil prices aren't about to drop under $70 a barrel in the future, right?

Third, the IEA estimates that output from existing fields will drop by almost two-thirds by 2030. The world is counting on oil from BP's deepwater wells, from Canada's oil sands, from Venezuela's tough-to-refine heavy oil deposits, and from new finds and increased production from fields in high-cost environments such as Siberia and the offshore Arctic.

On March 9, the US Department of Energy raised its oil price forecast (for West Texas Intermediate) to $85 a barrel by the end of 2011. With oil trading near $80 a barrel now, that forecast price for almost 21 months from now appears very low, unless you're counting on a double-dip recession for the US and global economies.

That possibility—and the fate of my April 2008 forecast—should be a reminder that extending any trend line into the future is tricky. So what could stop oil prices from rising at the rate that I now expect?

  • A double-dip recession in the global economy. A recession in the developed world won't do the job, mind you. The IEA forecast for 2010 already calls for a drop in demand in the world's developed economies of 0.3%—120,000 barrels a day—in 2010. Global oil demand is being driven by China and the rest of the developing world. Developing Asia, for example, will account for half of total growth in demand in 2010. By 2025, the IEA forecasts, China will pass the United States to become the world's biggest spender on imported oil and natural gas.
  • A global glut, or at least expanding supplies and falling prices, in natural gas. The IEA predicts a glut of natural gas of 200 billion cubic meters by 2015, thanks to expanding supply from unconventional sources in the United States and increasing exploitation of conventional gas reserves in the Middle East and other OPEC (Organization of Petroleum Exporting Countries) countries. Unfortunately, natural gas can't yet be easily substituted for oil for transportation. In the United States, transportation accounts for about two-thirds of oil demand.
  • The rest of the world uses more oil (as a percentage) for heating and power generation than the US. In those areas, cheap natural gas will indeed replace expensive oil, holding down price increases. But most of the oil demand growth in the developing world is coming from the transportation sector. In 2005, vehicle use accounted for just one-third of China's total oil consumption. But by 2030-2041, a study by the Argonne National Laboratory in Illinois projects, oil demand for road transportation in China will equal that in the United States. The annual growth in oil demand from road transportation in China will be between 3.9% and 5.1% from 2005 to 2050, the study concludes. That growth in transportation demand for oil decreases the likelihood that lower natural gas prices will significantly restrain rising oil prices.
  • A transition in transportation uses from oil to biofuels and increases in auto fuel efficiencies. I think this is the one big thing that could significantly cut into oil demand growth and make predictions of $200-a-barrel oil wrong again. Brazil already produces ethanol from sugar cane at a cost of $36 to $43 a barrel, according to estimates from Brazil's Bank for Economic and Social Development. If you've spent decades fostering a flex fuel auto industry—the ten millionth flex fuel car rolled off Brazil's auto assembly line on March 4—that makes ethanol a hugely attractive substitute for gasoline when oil is selling for $80 a barrel. No wonder Brazil's ethanol industry is in the midst of a merger-and-acquisition boom as players scramble to grab share. (For more on that, and why you want to own Brazil in your portfolio, see this February 5 column.)
  • Short of building a flex fuel auto industry (and no reason other than a lack of political will that other countries can't), the best way to reduce oil demand in the transportation sector is by increasing auto miles per gallon. The higher oil prices are, the more attractive hybrids and all electric cars become.

I think a number of investing ideas fall out of this forecast for rising oil prices. You can, of course, buy oil producers. I'd favor the shares of the few national oil companies that will let you buy in—Norway's Statoil (NYSE: STO) and Brazil's Petrobras (NYSE: PBR)—as well as companies such as Apache (NYSE: APA) that specialize in getting more oil out of old fields. (Apache has been on Jim's Watch List since December.)

The pick-and-shovel (in this case, drill-bit-and-drill-ship) companies are also good bets if oil prices are headed up over the long term. I'd favor Jubak's Picks holding Transocean (NYSE: RIG) and, after the merger dust has settled, Schlumberger (NYSE: SLB). I'd also take a look at some of the big Brazilian agricultural companies, such as Cosan (NYSE: CZZ), Bunge (NYSE: BG), and Vale (NYSE: VALE), a big iron ore producer that has recently moved into fertilizer production.

NEXT: Jubak's Picks Fourth Quarter Performance

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Jubak’s Picks Fourth Quarter Performance

Jubak's Picks, my portfolio designed for a 12- to 18-month holding period, returned 3.9% in the fourth quarter of 2009.

That trailed the major indexes. For the quarter, the Dow Jones Industrial Average climbed 7.4%, the Standard & Poor's 500 Index was up 5.5%, and the Nasdaq Composite Index was up 6.9%.

For the year, the Jubak's Picks portfolio was up 21.3%. That was slightly ahead of one of the major indexes. For 2009 the Dow industrials were up 18.8%, the S&P 500 was up 23.5%, and the Nasdaq rose 43.9%.

The portfolio's total return, since inception May 7, 1997, is now 282%.

My problem all year was that I never quite trusted this rally. In retrospect, I was dead wrong. The rally that began in March 2009 was—or maybe that should be "is"—one of the great recovery rallies in market history.

How great? Well, the selloff of early 2010 took the performance of this recovery rally down enough so that, as of February 4, the rally merely matched the record recovery rally of 1982. That 1982 rally ushered in what turned out to be an 18-year bull market.

So after the recent correction, this recovery rally is only tied for the greatest recovery rally in market history.

It's hard to match the performance of that kind of rally when you don't trust it and continue to hold a big chunk of cash out of the market. Jubak's Picks ended the third quarter of 2009, for example, with 27% of the portfolio in cash. I put some more in work in the fourth quarter, but still finished that period with 20% of the portfolio in cash.

If you were holding 20% cash and wanted to match the 7.4% of the Dow Jones industrials for the fourth quarter, your stock picks needed to return about 9.3% for the period. Mine would've clocked in with a 4.25% return if you'd eliminated the drag of cash.

For the year, my large cash position didn't cause nearly as much underperformance (unless, groan, you compare it with the Nasdaq). That's because by being 40% or so in cash in the first quarter of 2009, I didn't take nearly as big a hit as the major indexes did when the market continued its swoon. For that period, the Dow was down 13.3% and the S&P 500 was down 11.1%. The Nasdaq Composite dropped just 3.1%.

The lesson here is pretty obvious: When you're in one of the greatest recovery rallies of all time, nothing beats putting all your cash on the table and riding the hot hand.
That's not to say that I couldn't have done better—even with this cash position—if I'd done a better job of stock picking.

If you doubt the rally, you'll sell some winners too soon.

For example, on September 22, I sold Joy Global (Nasdaq: JOYG) at $49.54 a share after roughly a 33% gain in a month. It closed the year just $2 a share higher. But then proceeded to tack on an additional $8 a share by February 12. That's a 20% gain I could have picked up, with perfect hindsight.

And sometimes I definitely sold a winner because the gains made me nervous and I switched into a seemingly safer stock that dropped faster than the winner I'd sold. So far, my buy in the fourth quarter of Ritchie Bros. Auctioneers (NYSE: RBA) has definitely worked out that way.

I mention these mistakes not so much to beat up on myself—I haven't found self-flagellation a useful investment technique—as to illustrate an important investment lesson.

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The past does influence the way we invest in the present. And it's awfully hard to put money into stocks just after a bear market has kicked the stuffing out of your portfolio and delivered a stiff kick to your self confidence.
 
In reality, although I wish I'd matched the indexes this year, I'm pretty proud that I managed to stay invested to the degree that I did. Yes, 20% or 30% cash was a lot of carry this year, but it sure beats being 100% on the sidelines. And 2008 made the sidelines look very tempting.

I didn't stay in the market because I'm an especially courageous investor. I don't think I am, in general.

But I do know my market history. I do know that one of the reasons that bear markets are so devastating to investors' portfolios is because they stay on the sidelines nursing their wounds during the most powerful stages of any recovery rally. I was determined not to miss out on all the goodies if this rally turned out to be the real thing.

And I know that the other reason that bear markets are so devastating is that investors who miss the bulk of a big recovery rally are then driven by regret into plunging whole hog into the recovery rally just as it peaks. They then get killed in any subsequent correction. Or absolutely massacred if the recovery rally turns out to be a rally in a long, secular bear market.

So I'm relatively happy with my 21.3% in 2009. I'm not scarred by missing out on all the fun, and I might even be able to play it appropriately safe in 2010 for what promises to be a very, very tough year to read.

By the way, I don't think the rally of 2009 has by any means put a definite end to the possibility that we're in a long-term bear market that began in 2000. Remember that the last great bull market ran for almost 20 years. A secular bear could last just as long. (For more on this possibility, see this February 19 column.)

And a three- or four-year bull market rally inside a secular bear wouldn't be unheard of either.

Jubak's Picks Versus Major Averages

Index

Fourth Quarter Return

2009 Return

Jubak's Picks

3.9%

21.3%

Nasdaq Composite Index

6.9%

43.9%

S&P 500 Index

5.5%

23.5%

Dow Jones Industrials

7.4%

18.8%

Longer-Term Performance

 

Three-Year Return*

Five-Year Return**

From Inception***

Jubak's Picks

0.50%

52.90%

282%

Nasdaq Composite Index

-6.20%

4.30%

71.50%

S&P 500 Index

-21.40%

-8%

37%

Dow Jones Industrials

-16.40%

-3.30%

47.20%

*From the market's close on December 29, 2006, through the close on December 31, 2009.
**December 31, 2004, through December 31, 2009.
***May 7, 1997, through December 31, 2009. All returns for Jubak's Picks deduct costs of commissions on each buy and sell. Returns for Jubak's Picks and the indexes include dividends.

The Jubak Picks 50 Portfolio

A final, but very preliminary word on the performance of the Jubak Picks 50 portfolio that I started tracking on December 30, 2008. The return on that portfolio based on my 2008 book, The Jubak Picks,was 28% for the six months ending June 30, 2009. And now, with this rally, the return has climbed to 50.5% for the full year.

Now, short-term returns don't mean much. Especially when they start, as these do, from a depressed level in a bear market and have the good luck to catch a huge market rally. Still, I'm encouraged to see that in an up market, this portfolio has outperformed the 23.5% return on the S&P 500 for 2009. The chances that this long-term portfolio could beat the S&P in the long haul would be very slim if it lagged badly during a market like this.

It remains to be seen how this portfolio will do, comparatively, in a selloff.

It takes a good ten years for a portfolio to prove itself. Still, I'd rather start out 50.5% ahead than 50.5% behind. It's better than a poke in the eye with a sharp stick.

At the time of publication, Jim Jubak owned shares of the following companies mentioned in this column: Apache, Statoil, Transocean and Vale.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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