Table of Contents:

• Oil Production: Why OPEC’s Keeping a Lid on Production
• Oil Prices: Why Crude Thrives on the Diving Dollar
• Oil Outlook: The Coming Oil Price Shock
• Investing in Oil: The Best Companies, Stocks and ETFs

Oil has staged an impressive rally since dropping below $35 a barrel in mid-February.
And while there remains a risk that prices will retreat further due to sluggish demand, there are also three very compelling reasons why oil is still a safe long-term bet:

• OPEC has made substantial progress in reducing the amount of oil on the market.
• The dollar has been made vulnerable by the U.S. Federal Reserve’s aggressive policy of quantitative easing.
• And low oil prices and tight credit have reduced global energy investment, putting future supply at risk.

There’s no question that downside risk remains. On April 13, the Paris-based International Energy Agency (IEA) lowered its demand forecast by 1 million barrels a day, and now expects the world will use about 83.4 million barrels per day in 2009. That would be 2.4 million barrels a day, or 2.8% less than last year.

But so far dwindling demand has failed to contain oil prices.

As Money Morning predicted in its annual outlook series, the first quarter was a volatile one, in which oil prices tested the low $30s before surging over $50 in recent market rally.

And analysts are almost completely united in the view that, despite its short-term volatility, declines in production, exploration and development, and the value of the dollar will drive oil prices substantially higher in the years ahead.

Oil Production: Why OPEC’s Keeping a Lid on Production

The members of OPEC generated tremendous revenue from oil prices that soared over $147 a barrel last year. However, just as the world’s top oil producers began looking for ways to spend their massive stockpiles of cash, prices began a plunge that would see crude lose more than three-quarters of its value.

In a desperate effort to put a floor under oil prices, OPEC – supplier of 40% of the world’s oil – has issued three production cuts totaling 4.2 million barrels per day (bpd), or nearly 12% of its capacity, since September.

While the cuts have not yet been able to return oil prices to the group’s desired price range of $60-$70 a barrel, the cartel abstained from making any further reductions at its latest meeting in March and even voiced optimism that crude would reach $60 a barrel by the end of the year.

“That suggests to us that not only does OPEC have the firepower to support this oil price, but there’s enough internal agreement between OPEC members that they can actually achieve it,” Tom Nelson, an analyst for the Guinness Atkinson Global Energy Fund told BusinessWeek.

Many analysts had speculated that OPEC members would ignore the quotas and continue to produce oil to generate income, thereby rendering the cuts ineffective. But OPEC’s discipline has proven many critics wrong.

Despite foot-dragging from Iran and Venezuela – two countries that rely heavily on oil revenue to fund massive social programs – OPEC has gotten about 80% compliance on the 4.2 million bpd production cut. Historically, the cartel only gets about 60% compliance on such cuts.

As of February, Saudi Arabia accounted for about 46% of the 3.4 million bpd decline in production, according to PFC Energy. And the United Arab Emirates have fully complied with their share of the cuts. Iran’s compliance by that time was only 33% and Venezuela had only adhered to half of its commitments.

Still, Abdallah El Badri, OPEC’s Secretary General, estimates the production cuts will take about 800,000 bpd of supply off the market, significantly reducing the overhang in global markets, BusinessWeek reported.

OPEC officials from Libya, Algeria, and Iraq have all said that oil prices will reach $60 a barrel by the end of the year.

“One of the reasons why OPEC felt able to roll over quotas was that they do appear to have set a floor for prices,” Mike Wittner, an analyst at Societe Generale SA (ADR: SCGLY), told Reuters. “According to a lot of the balances, including ours, if you have OPEC holding steady or cutting a bit more, you get a big, counter-seasonal stock draw in the third quarter.”

Oil Prices: Why Crude Thrives on the Diving Dollar

Crude futures doubled from July 2007 to July 2008, soaring from about $74 a barrel to a record-high $147 a barrel. Much of that rise can be attributed to supply and demand, but there was another catalyst for the soaring prices that few investors recognized: The rapid decline of the dollar.

From July 2007 to July 2008 the dollar plunged 16% against the euro. And as the dollar became less valuable the cost of commodities around the world skyrocketed.

At the time, inflation – not deflation – was the predominant concern among the world’s leading economists, as a decade of low interest rates and unconstrained lending in the United States sucked the life out of the dollar. And while inflation is nowhere near the levels it reached last year, it’s important to recognize that the policies of the U.S. Federal Reserve are no less inflationary.

The Fed has cut its benchmark lending rate to a range of 0%-0.25%, and soon after, Fed Chairman Ben S. Bernanke said the central bank would purchase up to $300 billion of longer-term Treasury securities and $750 billion of mortgage-backed securities as it pursues a policy of quantitative easing.

This announcement by the Fed, along with a corresponding rise in equities, has been the driving force behind oil’s recent rally.

Ultimately, the same fear of inflation that typically drives investors into the gold market is similarly buoying oil prices. And even though the dollar has yet to be seriously affected, there’s no ignoring the fact that the more than $1 trillion worth of government bonds and mortgage-backed securities injected into the market will imperil the dollar’s value.

Oil Outlook: The Coming Oil Price Shock

Now that a weak dollar and reduced production have bolstered oil prices, there is a growing concern about how much higher crude will climb once demand returns. Tighter lending conditions and a trough in oil prices have badly crimped investment and jeopardized future supplies.

More expensive energy projects such as oil sands have been put on hold and the number of drilling rigs at marginal shallow-water fields around the world has been scaled back to a three-year low.

Oil drilling activity dropped 43% in the 12 months through March, with year-over-year oil exploration in the United States alone down 38%. High bids for offshore drilling rights in the central Gulf of Mexico fell by more than 80% compared with last year.

OPEC has said that with oil generating substantially less revenue as many as 35 new projects could be delayed past 2013.

“I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion,” said Ali al-Naimi, the Saudi oil minister. “If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices.”

The current economic crisis could reduce future oil supply growth by 8 million bpd, according to a recent study by the Cambridge Energy Research Associates (CERA).

CERA now says that production will grow by just 7.5 million bpd over the next five years, down from the 14.5 million bpd increase it predicted last summer. According to the research group, as demand recovers throughout that span, production will struggle to keep up and a new commodities bull market, similar to the one seen in 2008 will begin.

“Seven consecutive years of rising oil prices – unprecedented in the history of the oil industry – have come crashing down, thus burying the notion that the commodity price cycle was a historical relic,” said the report.

CERA isn’t the only organization worried about the lack of investment in new oil projects, either. The International Energy Agency (IEA) – energy advisor to 28 industrialized nations – has also issued warnings about a coming supply crunch.

The IEA estimates daily oil demand will rise from the current level of 86 million barrels to 106 million barrels by 2030. To meet that demand, the agency estimates that the world needs $26.3 trillion in supply-side investments over the next 21 years.

China, India and other developing countries, alone, will need investments of $360 billion a year through 2030, the agency said.  About 7 million bpd of additional capacity needs to be added to the market by 2015.

“Unless sufficient companies have the will and financial ability to invest through the down cycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases – possibly as early as this year,” Richard Jones, the IEA’s executive director said at a recent conference in London.

Jones estimates that as much as 2 million bpd of expected new oil production has already been deferred.

The IEA predicts that, by 2015, a lack of investment and rising demand will create a “supply crunch” – that will once again send oil prices up into the triple digits.

“There remains a real risk that under-investment will cause an oil supply crunch in that time frame,” the IEA said in an executive summary of its “2008 World Energy Outlook.” “The gap between what is currently being built and what will be needed to keep pace with demand is set to widen sharply after 2010.”
The agency predicts that crude will average more than $100 a barrel from 2008 to 2015 and rise above $200 a barrel by 2030, as demand far outpaces supply.

“Every bull market in oil is really born in the zenith of a bear market,” said Phil Flynn, an analyst at Alaron Trading Corp. “The cutbacks we see today are going to lead to a spike somewhere in the future. The big question is when it’s going to happen.”

Investing in Oil: The Best Companies, Stocks and ETFs

When it comes to investing, the oil sector poses some very clear risks, especially given the murky near-term outlook. However, there are a number of large-cap integrated oil companies that may offer some truly compelling values at current prices.

Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) are currently trading at multi-year lows, making them exceptionally cheap in both relative and absolute terms. These companies also have strong balance sheets (Exxon is “AAA”- rated and has more cash on its balance sheet than debt), generate strong cash flows, and have traditionally increased their dividends on a regular basis.

”Chevron is the kind of company that is capable of continuing to post large profits – propelling its share higher from current levels – even if oil-and-gas prices were to drop from current levels over the next three years,” Money Morning Contributing Editor Horacio Marquez said. “That’s because Chevron’s business is well cushioned, since refining, marketing and chemicals margins would expand dramatically if market ’spot’ prices were to decline. Also, the company’s production is poised to expand strongly and Chevron uses some selective hedging that works very well in downside oil markets.”USO

Offshore drillers, particularly those capable of drilling in the deepest waters, also offer value at current levels. Petroleo Brasileiro (PBR), also known as Petrobras, is particularly appealing, as it recently discovered one of the largest offshore oil fields on earth off the coast of Rio de Janeiro. Known as Carioca, the field could hold 33 billion barrels of oil and gas, making the world’s largest discovery in at least 32 years.

Keith Fitz-Gerald, Money Morning’s Investment Director, suggests investors look at China National Offshore Oil Corporation, or CNOOC Ltd. (ADR: CEO). The Hong Kong-based company recently got approval for a $29 billion exploration project in the South China Sea. The company expects to produce 50 million tons of oil equivalent per year from that region during the next 10-20 years. That would equal the production of China’s biggest project, the Daqing Oil Field.

Petrobras and CNOOC are also attractive because, as foreign companies, they will also get a boost from any devaluation in the U.S. dollar.

All of these companies have been hit hard by the combination of commodity-price weakness and credit market turmoil. But these operators do not require peak-cycle commodity prices to generate stellar results and have little or no credit-market exposure.

For a more direct play on oil prices, you might also try an exchange-traded fund (ETF), such as the United States Oil Fund LP (USO), the iPath S&P GSCI Crude Oil Total Return Fund (OIL), or the United States Gasoline Fund LP (UGA).

Source: Three Big Reasons Oil Prices Will Rally Back Big Time

This from Jason:

“I’ve been buying American stocks,” Buffett said in an editorial in The New York Times. “This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds… If prices keep looking attractive, my non-Berkshire net worth will soon be 100% in United States equities.”

As the world’s richest man, Buffett offers a kind of comfort that few others can.  And it couldn’t come at a better time. The fourth quarter of 2008 was the worst quarter for the Standard & Poor’s 500 Index in more than two decades, as the closely watched stock-market benchmark tumbled 23%.

It’s likely that even Buffett took the same bath as the average investor.

In separate filings with the U.S. Securities and Exchange Commission (SEC), Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK B) said it spent $9.45 billion on equity securities in the first nine months of last year, Bloomberg News reported. Among the purchases:

• Berkshire bought a majority stake in U.S. Bancorp (USB) over a period of time that never saw the bank’s share price drop below 29.09, according to Bloomberg News. That stock is currently trading at less than $15 a share.

• Berkshire increased its Ingersoll-Rand Co. (IR) stake six-fold last year when the shares never fell below $36.54. That company’s stock has lost about half its value since Buffett made those purchases.

• And Berkshire stocked up on shares of Eaton Corp. (ETN) between July and September  – a stretch in which the stock never fell below $52.32.  Eaton closed yesterday (Wednesday) at $44.36 a share.

With such ill-timed purchases, some analysts are beginning to think that “Warren” has lost his touch.

“People like to second guess Warren Buffett, but it’s not just a flip question to ask if he should have kept his powder dry a bit longer,” Jeff Matthews, author of “Pilgrimage to Warren Buffett’s Omaha” and founder of Ram Partners LP, told Bloomberg. “He’s paid dramatically higher prices than where some of them are now trading at, so you have to wonder if he was too quick on the trigger.”

But, as a long term investor who has said that his favorite time to hold a stock is “forever,” Buffett sees things differently.

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year – from now,” said Buffett.  “What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

To support this claim, Fortune points to a long-revered Buffett metric: Total U.S. stock value versus gross national product (GNP). According to Buffett, stocks are a logical investment when their total market value equates to 70%-80% of GNP. And right now, it does.

In late January, total stock value equated to just 75% of GNP, down from a record peak of nearly 200% in March 2000. Indeed, for most of the past decade, the ratio of stock value to GNP has ranged from 150% to 190%. That makes now an ideal time to buy. And Buffett continues to do just that.

What Warren’s Buying

In addition to taking healthy stakes in U.S. Bancorp, Ingersoll-Rand, and Eaton, Buffett also committed $4.7 billion to Constellation Energy Group Inc. (CEG), $5 billion to Goldman Sachs Group Inc. (GS), and $3 billion to General Electric Co. (GE) last fall.

Buffett has also spent the past few years stocking up on railroad stocks, especially Burlington Northern Santa Fe Corp. (BNI). Berkshire’s most recent purchase of 2.6 million shares took its stake to more than 76 million shares – in excess of 20% – of the nation’s second-largest railroad.

And last week, Berkshire threw in a few surprises.

After buying 3% of Swiss Re (OTC: SWCEY) in January 2008, Berkshire last week poured another $2.6 billion into the world’s second-largest reinsurance company. Swiss Re has lost about three-quarters of its market value since Buffett’s original investment – further evidence that the investing icon remains undaunted by his losses.

Berkshire agreed to buy $300 million of corporate debt issued by motorcycle icon Harley Davidson Inc. (HOG). The senior unsecured notes purchased by Berkshire offer a 15% annual interest payment, making it one of Buffett’s many recent fixed-income investments.

Buffett agreed to buy $300 million of debt from USG Corp. (USG) in November, and his preferred shares of Goldman Sachs offer a 10% yield. The $2.6 billion he put into Swiss Re was accompanied by a 12% yield.

“He’s got cash coming in faster than most people would have a ready place to put it,” Frank Betz, a partner at Carret Zane Capital Management, which holds Berkshire shares, told Bloomberg. “This economy is certainly providing him with opportunities.”

With about $30 billion in cash on hand at Berkshire Hathaway, analysts are wondering where Warren’s going to strike next.

There is some speculation that if Berkshire shares continue to slide, Buffett could order a share buyback.

In the past, Buffett has said a company must meet two conditions to warrant buybacks of its stock: “First the company has available funds – cash plus sensible borrowing capacity – beyond the near-term needs of the business and, second, finds its stock selling below its intrinsic value, conservatively calculated,” he said.

Shares of Berkshire are down 37% in the past year and there’s little doubt that Buffett has the money.

Of course, Buffett also said last month in an interview with PBS that he would notify shareholders of his intentions before engaging in a buyback program.

“If I ever name a number, I’ll name it publicly,” Buffett said. “I mean, if we ever get to the point where we’re contemplating doing it, I would make a public announcement.”

The last time Buffett made such an announcement was nine years ago.

Another possibility is that Berkshire will invest in energy companies with large holdings in oil sands – notably Calgary-based Nexen Inc. (NXY).

Buffett, along with Microsoft Corp. (MSFT) mogul Bill Gates visited the Athabasca Oil Sands region in northeastern Alberta last August.

“The world will be using more oil 15 or 20 years from now,” Buffett told the Financial Post in an interview. “We are on a course that cannot be changed. It would surprise me if the world doesn’t want to use 100 million barrels a day in 15 or 20 years.”

“You need some … elephant fields [of oil to meet looming demand] and we haven’t found any elephant fields in the last 15 or 20 years,” he added. “So the sands are huge.”

However, some analysts remain skeptical.

“Seems there is a rumor that Berkshire is interested in Nexen – no one can give me comfort that this is indeed the case – they haven’t bought into [exploration and production] names before … but stranger things have happened,” investment bank Scotia Capital wrote in a note to clients.

What Buffett will do next remains unclear, but there is one certainty: He won’t be sitting on the sidelines and hoarding cash.

“Today, people who hold cash equivalents feel comfortable. They shouldn’t,” Buffett wrote back in October. “They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value,” Buffett said in October.

“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘I skate to where the puck is going to be, not to where it has been’.”

Source: Buffett Bargain Hunting Despite 2008 Losses