Has Oil Hit Its Peak Price?

Has oil hit its peak price or not? The answer to that question leads us to ask whether or not commodities are a bubble about to burst. Barron’s recent cover story on commodities came down on the side that the party was over.

I don’t put a lot of faith in macro predictions – as no one can predict the future. But you can study track records. You can look at history. History reveals some interesting clues about what the future may hold.

The quick take? It doesn’t look like the party is over just yet. But even if it is, past peaks in oil give us clues. When you dig a little deeper into those relationships, you find a great road map for making money.

If you look at the price of oil, you find something interesting. Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply, as this next chart shows:

Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.

The other thing to remember – and people forget this by worrying excessively about a U.S. recession – is that the story of oil is no longer a U.S.-centric story. You’ve surely heard about how the rapid growth in China and other emerging markets drives oil demand. Well, it’s good to keep that in mind.

China and India are only beginning to consume oil at any meaningful level. Right now, they are consuming oil at a rate the U.S. did in the early years of the 20th century. But look, we don’t need China to start guzzling oil like we do. Even if it moves half the distance between it and Hong Kong, that’s a lot of extra demand. The way I look at it is this: What’s more likely, China stays at 1910 oil usage or moves somewhere closer to, say, 1950s U.S. oil usage? I think the latter.

Mark Mobius, in a column he wrote for the Financial Times , points out that the fundamentals in emerging markets are better than they’ve been in a long time. The future looks bright. “The Chinese and Indian consumers are the world’s new consumers and they, along with consumers in Brazil, Russia, Turkey, the United Arab Emirates, Egypt, Mexico, Poland and many other emerging markets, are becoming an important force in global markets.”

All that bodes well for oil demand. But I haven’t really gotten to the best parts yet…

Even if oil has already peaked, that doesn’t mean oil is headed back to $40 per barrel or lower. In fact, if this oil boom follows history at all, we’re looking at years of oil prices right around $100 per barrel.

It is important to realize that in no prior oil boom did the price of oil retreat rapidly toward where it was before the boom began. In each case, the price of oil stayed up for years after the peak. That ought to give you some comfort about our current situation. The price of oil should stay up here for years. If his estimate of 2013 is at all close, we’ve got plenty of time left to make a lot of money.

So where do you go to make that money?

The one obvious place people will automatically look to is to own oil and gas producers. That’s not a bad idea at all. But I’ve got another angle here. The next two charts are amazing. They show you the capital and exploration spending of both Exxon and Chevron from 1928-2007. They show spending bottoms in 1948 and 1974. After each bottom, there was a long run of spending. Spending peaked nine years after 1948. Spending peaked seven years after 1974. If 2005 proves to be the bottom on capital spending – and it seems so, since Exxon only recently announced it would increase its capital spending to $25-30 billion over the next few years, a 25% increase -we won’t see capital spending peak until 2012 at the earliest.

Now, why is this important? Think about what the oil companies spend money on. Where do they go shopping? They go shopping at the oil field services and equipment companies.

So that is where we want to be. Because even if oil has peaked, we’re still looking at years of strong spending by the oil companies. You want to have some exposure to the receiving end of all that spending. Such companies will mint cash. And they give you a little different payoff than owning a straight producer. It can sometimes be better to own the picks and shovels. You don’t actually own or produce the oil or gas, but your equipment is vital to those that do.

Newmont Mining, the big gold producer, is an example of a producer that has profoundly disappointed investors amid what may be the greatest gold bull market in history. Newmont’s costs rose so fast and so much that it never really enjoyed (at least not so far) the higher price in gold. But if you were in some mining equipment manufacturer, you got paid.

So the key takeaways here are these: The price of oil has room to run yet, in part because of the growth in money supply and in part because of pressing international demand. Secondly, even if we already saw oil peak, history says that prices won’t retreat by much over the next several years. And finally, the capital spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies.

The big idea here is well servicing…

It’s really a great and kind of sneaky way to play an undeniable trend in oil and gas: the depletion of older wells past their peak production. Well servicing helps you get a little extra out of every well. A well service rig is the workhorse that does the well servicing.

Here’s the life cycle of a typical oil well…

Every time somebody drills a well, it creates an annuity for the well service industry. That’s because the maintenance work follows the life span of a typical well. If you don’t service your well, your production rate declines much more rapidly. So if you want to stay in business, you keep servicing your existing wells. You may not drill new ones, but you keep what you have.

The second key to remember is this: The more mature the oil or gas field, the more well servicing work needed. Well servicing doesn’t typically have the same ups and downs as exploration. Well service fleets provide much more durable and predictable cash flows. I expect all that money the big majors spend on exploration will lead to a lot of new drills and a long tail of new business for well servicing companies.

Chris Mayer
for Markets and Money

Chris Mayer
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in Markets and Money. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.

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Herbert Ripin

Chris Mayer, any comment on Mat Badiali’s negative opinion on APL?

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