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Investing in a Slippery Business

by Juno Moneta
May 31st, 2008, 2:03 pm

Why is the price of oil so high? And how can you get a cut of the action?

The price of oil is mainly affected by four factors: 1) demand, 2) supply, 3) the value of the U.S. dollar, and 4) the performance of the stock market.

Demand

Right now demand is high because we all need oil to function. Not only to fuel our cars and planes, but also to create anything made out of plastic. Plus, consumer behavior doesn’t change that fast. Even now that gas costs 4 bucks per gallon where I live, I look around when I’m commuting to work, and all I see are SUVs. Smartcars and Priuses are the exception, not the norm.

And think about it — everything made of plastic has petroleum in it. Take a look around you and count how many things are either made of plastic or packaged in plastic at some point. That’s a lot of oil. Add to this the fact that growing economies like China and India have incredibly high demand for oil that will continue to grow for decades. So even if everyone in the U.S. and Europe switched to Priuses and started using plastic made out of biodegradable corn husks or something, overall global demand for oil would continue to rise because of developing nations with exploding populations.

One more thing about demand - major oil producing countries subsidize the heck out of gas in their own land. In Saudi Arabia, for example, you can buy gas for 45 cents a gallon, and in Venezuela, you can gas up for 25 cents a gallon. 25 cents!!!! So those folks certainly aren’t going to go out and buy Priuses or cut back on driving. Given all of these factors, I don’t see demand for oil decreasing on a global scale any time soon.

Supply

The fact that oil producing countries subsidize their gas at home means that as more of their own citizens consume their oil, they have less to export, meaning there is a smaller supply of oil left for the rest of us.

Also, the major oil companies have been pretty slow to proactively go out and look for new sources of oil. Instead, they’ve been satisfied with resting on their existing supplies. But now that demand is so high and growing higher, and the existing supplies are running out, these companies have finally starting going out and looking for new places to drill in the past few years. But guess what? It takes 7-10 years to get from the “exploring for new sources of oil” phase to the “first production” of oil phase. So we’ll have to wait awhile for that new oil. Also, many analysts believe that there’s not much new oil to be found, even in potential (and controversial) new drilling places like Alaska, or off the coast of Florida and California.

Another supply side issue is that most major oil-supplying countries are either at significant risk because of local instability (Iraq, Nigeria, Saudi Arabia), or they belong to countries that are not exactly U.S. friendly (Iran, Venezuela, Russia).

So while Saudi Arabia is the largest OPEC producer and it’s government is pals with the U.S., there is still the risk that al-Qaeda terrorists could attack its oil-producing infrastructure or that the government could be overthrown by radicals. This would send the price of oil soaring. Similarly, oil prices will skyrocket if current hostilities between the U.S. and Iran flare up. All of these scenarios would drastically reduce the supply of oil on the world market and drive the price up, up, up.

Value of the U.S. Dollar

Oil is valued in U.S. dollars. So when the dollar is weak, oil is more expensive, because it takes more dollars to buy the same amount of oil. Conversely, when the dollar is worth more, oil is cheaper. Over the past year, the dollar’s value has been so miserable that the Organization of the Petroleum Exporting Countries (OPEC) considered valuing oil in Euros instead of U.S. dollars. But this week, the dollar’s value perked up and oil prices also went down a bit.

Performance of the Stock Market

When the stock market goes down, investors who aren’t in it for the long term (or people who are just spooked) look for other places to put their money. Which, of course, makes the stock market go down even more (thanks, guys.) And then those folks have just sold low and bought high (suckers!)

But anyway, these chicken-hearted investors often pour their cash into commodities, including oil. So that in turn, drives the price of oil up. A couple of days ago, the price of oil fell by a few dollars, which was probably due to some of those short term investors cashing in on their gains, in addition to the rise of the U.S. dollar’s value.

How to Cash In

Okay, okay. So the future is grim. How can a girl go about finding the silver lining of this disastrous oil scenario? Invest in winners and watch out for losers.

Winners include funds that invest in major oil-producing countries, which are getting rich, rich, rich every time you pay $4 at the pump. T. Rowe Price has an Africa and Middle East Fund, and there are also Exchange Traded Funds (ETFs) that invest in these oil-producing hotspots.

Also, if you’re looking to invest in the stock of an oil and gas company, you may want to pick one with significant holdings in countries such as Canada that are stable and U.S.-friendly.

Another winner is the auto-insurance industry. As people drive less to conserve less gas, there are going to be less accidents. And that makes auto insurance profits go up.

Losers include companies that provide products to low-income Americans, who will have less disposable income as they fork over a greater percentage of their paychecks for gas. Companies like Wal-Mart and McDonald’s might experience a slowdown in business. Another loser is the already faltering airline industry. Consumers are super price-sensitive when it comes to flying, and the high fuel prices mean the airlines will suffer from higher expenses and a shortage of customers willing to fly.

Post Your Comments

Have you changed your behavior to consume less oil or energy?

Has the high price of gas made any real difference in your life?

Do you invest in commodities? How’s that working out for you?

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