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I cover the Energy sector on a daily basis and am more than willing to admit that I can't fully explain why oil prices have gone up so much. I will say that I disagree with Oppenheimer's comment from back in October though. I say this even though I respect the analyst who's name appears on that story. He's highly regarded in the industry and quoted regularly. At one time, he worked for Exxon, too, so he's got a lot of practical sector experience as well.

This op-ed piece from the NYT is also of interest on the topic of whether or not we're in a bubble: http://tinyurl.com/5tnnm2

First, I think one thing is pretty clear, we're not going to find any more cheap oil. Too a large extent I think this makes the question of peak oil much less important. The barrels we find or lift going forward are going to be much more expensive than the legacy assets that are out there. Because of that I like to think of the marginal cost of production (MCP) when I try to determine a fair price for oil; i.e., what is the cost of the last barrel produced (assuming a reasonable return on capital on that barrel as well). From what I understand, the most expensive oil we get right now is that which comes from Canada's oil sands. I've discussed this with a couple companies I cover, and their view coincides with the one I have -- the MCP is in the $60-$65 range. UK Consulting firm Wood MacKenzie set the MCP at $70. I don't think it's there yet, but it could be. Input costs, especially steel and labor, are increasing. There's also the impact of rising day rates, especially for deepwater rigs, where there is a current shortage on the supply side and demand is growing.

But, even if we set a price at $70, what's causing oil to be so much higher? Here's at least a partial list:

- the weak dollar;
- geopolitics;
- speculation;
- supply/demand; and
- uncertainty.

Excess capacity is falling and supply/demand are moving more in balance. I expect this problem to get worse before it gets better. The EIA http://www.eia.doe.gov/ projects that worldwide oil demand will be roughly 130 million barrels per day in 2030. Today, we're at around 87 million. Oil is a depleting asset. The most conservative depletion rate I've seen comes from CERA (Daniel Yergin's firm, which lies pretty much in direct opposition to the views of Matthew Simmons and the Peak Oil crowd), which placed depletion at 4.5% annually. If we deplete at that rate, and we grow anywhere near where EIA forecasts, we're going to have to find new sources of production about equal to what we're currently producing today. I find it hard to believe we'll do that.

Many projects are being delayed, we don't really know what kind of reserves the national oil companies (NOCs) of OPEC hold. The vast majority of the resources are held by these NOCs (around 80-85%), which makes everything quite complex, too. Non-OPEC production continually disappoints. Even Saudi Aramco's budget is growing (for example, it's booked several expensive rigs), which at least indicates it's getting harder to get that oil. There was recently a front page article discussing Sanford Bernstein's efforts to estimate Saudi reserves from aerial views. The results seemed somewhat inconclusive.

So, what can bring oil back closer to the MCP. I see two primary factors. The economic malaise of the US extends beyond our borders. It's important to note that in the first quarter, growth in non-OECD oil demand was strong enough to overcome the contraction in non-OECD demand, as worldwide demand grew by a little less than 1%. The other factor is that in many of the countries where demand is growing the government subsidizes oil/gas prices. At some point, I have to think oil prices get high enough that these subsidies become non-sustainable. But, that could take awhile, as that would also crimp growth and development in those countries. If the subsidies are cut, then consumption should fall. That would put downward pressure on demand and push prices lower.

So, I don't think the current price rise is solely based on fundamentals, but I don't think it's all speculative either. As is typical, it seems more likely the truth is somewhere in the middle.

As investors, the question is even more complex. If oil were to keep rising, then the cash flow created by the oil companies would likely grow even faster than it has been, making valuations appear particularly cheap. Natural gas (which converts to oil on a 6:1 basis) looks underpriced relative to oil. Rig and service companies are well positioned. I think it's unlikely we see a material pullback in exploration and drilling activity.

I think this post is long enough for now. I'll try and revisit to continue the discussion with anyone that's interested.

Phil
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