Why Not Oil Stocks?

Smart investors need to watch the oil market carefully because oil prices, more than anything else, determine the profitability of oil and energy companies. A decline or rise in oil prices will correlate with company profits, as you can see from Figure 1.

Oil price dynamics depend on supply and demand. The demand for oil is easy to forecast; it goes up. Unfortunately, the supply cannot be forecast as easily; trends can change suddenly. When higher demand necessitates increased supply and reaches a point where supply cannot keep rising or even starts declining, what's the result? Higher prices at the gas pump. The shortage results in a price shock. If you happen to own oil company stocks at those times, you will see immediate gains in your portfolio. That's why you should consider having some oil and energy stocks in your portfolio just in case an unexpected price shock takes place.

HOW THE OIL INDUSTRY WORKS

Oil exploration is not unlike gambling: The outcome is unclear. Since oil is underground, explorers cannot guarantee its availability. In the early stages of oil production, oil is scarce and prices are high. As exploration continues, oil explorers become more certain about the availability of oil. If they hit a pocket of crude, production increases and prices decline. Eventually, reserves run out and oil is scarce again, raising prices once more. Geological theorist M. King Hubbert emphasized the cyclical nature of discovery and production and proved that the existence of this cycle was evident in all mineral production industries.

Oil exploration and subsequent production start slow and increase as more information becomes available, and then decrease due to scarcity. Prices mirror this sequence, which means that prices start high, decrease due to greater production and then increase again when production slows. Prices of a nonrenewable resource such as oil can decline for years or even decades while production increases before a severe supply decline hits with a corresponding price shock.

Figure 2 shows the relationship between output and price of resource extraction. Once reserves start dwindling, production decreases, shortages appear, and prices rise drastically. Even with better technology, which improves oil extraction and increases efficiency, a severe price shock is possible. Indeed, technology can actually hide the magnitude of the scarcity until it overpowers technological advances. Thus, oil scarcity can be hidden from the economy until just before it hits with a price shock.

FIGURE 2: When production increases, prices gradually decline, but when production declines, expect price shocks.

WHAT TO WATCH FOR

Although oil stock price trends are unpredictable, there are a few clues that may help you forecast the next shock, using as examples those events that preceded previous oil shocks. Keep the following in mind:

• Heed the warnings from published oil reserve estimates. These estimates are usually from host governments and are often inaccurate, but the trends can be quite revealing. Over the last 10 years, increases in proven oil reserves have been ahead of oil consumption by an average of only one billion barrels per year. Before the 1973 oil price shock, increases in proven oil reserves were averaging 50 billion barrels per year ahead of consumption. This is a clear warning of an imminent decline in oil production.

• Take any announcements about huge, new oil finds in the Caspian Sea, China, or anywhere else with a grain of salt. Often, these new finds don't pan out or they have more gas than oil (and clearly, that's the topic of another article). Even if these new finds are that promising, long lead times are usually required to develop the fields. That can take as long as a decade.

• Don't assume that OPEC oil producers will increase oil production by large amounts. They are monopolies within their own countries. That makes them risk-averse to increasing oil exploration and development. In addition, they may have less oil than they think and certainly less oil than they say they have.

• Discount the "fuel cell cars or hybrid cars are going to save us soon" argument. It would take 20 or 30 years to replace the current auto stock. By then, oil shortages will be even greater.

To take advantage of the unpredictable price jumps in oil stocks, invest in oil companies. Everyone needs energy -- no matter what the price.

SUMMARY

While it is important to invest in growth industries, it may be a good idea to hedge your portfolio by including energy-related industries. Since oil price shocks can occur without warning, if you postpone investing in oil company stocks, you could lose out on substantial stock price gains in these industries. Not only that, there is a great deal of evidence indicating that increases in oil prices can affect other sectors in the economy; for example, a rise in oil prices increases transportation and shipping costs.

A well-diversified portfolio should not be without some oil and energy stocks to hedge against such a reversal of fortunes. Having all your eggs in one basket may not be wise. Put some of those eggs into well-selected energy industries. If you don't act now, you may miss your chance for the next price shock.

Douglas Reynolds is a professor of economics at the University of Alaska Fairbanks. His models of oil production have been published in several academic journals.

REFERENCE

Hubbert, M.K. [1962]. Energy Resources, A Report To The Committee On Natural Resources. National Academy of Sciences, National Research Council, Publication 1000-D, Washington, DC.