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The Case For Energy Stocks

Vincent Farrell, Jr., wrote a piece today analyzing oil prices and the likelihood that they will remain high. Since energy stocks are one of our largest holdings I thought you might like to read his thoughts. They very much mirror my own reasoning for maintaining an overweight position in energy stocks in spite of the main stream mindset that says in a recession you underweight energy.

Very near term, the price of oil is being greatly influenced by Turkey’s incursion into Iraq, Iran’s nuclear program, Exxon (XOM) vs. Chavez, violence in Nigeria and the consequent geopolitical instability and nervousness. All of these factors can reverse themselves — but I bet they won’t — and oil prices could calm down.

Looking beyond the immediate, I see nothing that would tell me that oil won’t stay high in price and move even higher over the longer haul. Supply and demand is in precarious balance. OPEC’s spare capacity is limited, and non-OPEC supply has continually disappointed. Oil is priced in dollars, and OPEC’s income vs. the other currencies they want and use is nowhere near what the dollar price says it is. Saudi oil fields are declining at a faster pace than they will admit.

The Saudis have never had as many rigs drilling with apparently little in the way of incremental production being brought on stream. People who figure such things say the Saudi budget would be balanced if oil were about $65 a barrel. Sixty percent of the Saudi population is under the age of 21. There is huge social network that the Saudis don’t dare let fray for fear of stirring even more issues with Islamic fundamentalism. Lip service notwithstanding, the Saudis want ever-higher prices.

Seventy-five percent of the world’s oil production is from fields discovered more than 25 years ago. Despite intensive drilling programs, the new fields are significantly smaller than the older discoveries. In other words, the easy stuff has been found.

Seventy-seven percent of the known oil reserves are controlled by state oil companies that, generally speaking, don’t like us very much. They have no incentive to do anything but maximize the price.

Demand continues to rise at an inexorable pace. The emerging nations let by the BRIC nations — Brazil, India, Russia and China — are now 30% of world GDP (the U.S. is 28%). Despite the U.S. housing crisis and the consequent credit crunch, these nations are still growing 5% a year. China, for example, has four times the number of people than the U.S. but only one-sixth the number of cars. Internal growth and the desire for life’s comforts — not to say status symbols — will continue to drive demand for oil. The U.S. uses about 25 barrels of oil per person per year. China uses less than 2 barrels per person. That number will soar as China’s middle class develops.

In 2005, the world consumed 31 billion barrels of oil, but the industry discovered only 12 billion. The inability to replace production has been an unfortunate constant the past few years. My best guess is that the price of oil will back off a bit as growth in the U.S. is, at best, sluggish. Oil averaged $72 a barrel in 2007. If I had to put a number on it, I think oil will average above $85 a barrel in 2008. I do expect seasonal softness as we exit the winter heating season, but for the factors mentioned above, I don’t think it will be too many years until we look back fondly at “only-$100-per-barrel oil.”

The logic above, in my opinion, is hard to argue with. We are in a different world than in previous recessionary times and the US is not the only game in town any longer. Stick with energy in your portfolio in spite of Wall Street telling you that Tech will provide superior long-term growth. The fundamentals are stronger with energy than tech, and your portfolio will perform better because of it.

Mark