WILL OIL HIT US$200 A BARREL AFTER ALL ? / MSN MONEY ( HIGHLY RECOMMENDED READING )

Jubak's Journal

3/15/2010 7:00 PM ET

Will oil hit $200 a barrel after all?

Those 2008 predictions of sky-high prices may not have been as wrong as they were premature.

By Jim Jubak

What ever 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 before the year was out. 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 10 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 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 U.S. 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 less than 1% 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:

- 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 (CVX, news, msgs), 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. And more of the wells that actually find oil are in extremely challenging geologies. On March 11, for example, BP (BP, news, msgs) paid Devon Energy (DVN, news, msgs) $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 deep-water 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 U.S. 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 U.S. 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 U.S. 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 2030-41, 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 10 millionth flex-fuel car rolled off Brazil's auto assembly line 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.

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 (STO, news, msgs) and Brazil's Petrobras (PBR, news, msgs) -- as well as companies such as Apache (APA, news, msgs) that specialize in getting more oil out of old fields.

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 Pick Transocean (RIG, news, msgs) and, after the merger dust has settled, Schlumberger (SLB, news, msgs). I'd also take a look at some of the big Brazilian agricultural companies, such as Cosan (CZZ, news, msgs), Bunge (BG, news, msgs) and Vale (VALE, news, msgs), a big iron ore producer that has recently moved into fertilizer production.