Investing In Oil: The Fundamentals

What are the fundamentals that are driving my investment decisions to focus generally on the oil sector? This article is my attempt to answer this question in simple terms using common sense.

First, as exciting as it sounds, this article will NOT be covering the following subjects: peak oil, life after oil, demand outpacing supply in the future, oil dependent economies crumbling or better yet world resources wars. This article will cover the fundamentals for investing in the oil sector for at least the next decade as a time frame.

Uses of Oil

It is no secret that oil is in use all around us. Oil is refined into products such as fertilizers for farms, the clothes you wear, the toothbrush you use, the plastic bottle that holds your milk, the plastic pen that you write with. There are thousands of other products that come from oil. Almost all plastic comes originally from oil. Refining a barrel of crude oil produces the following products:

It took Mother Nature millions of years to produce this fossil fuel. It is in finite supply, the demand is there and our world is dependent on it!

A Path of Growth

Economic growth is accelerating all over the world particularly in Asia and Latin America. A new middle class is emerging looking to reach the same standard of living we enjoy in the West.  Here’s a chart for global GDP growth produced by the IMF:

Please focus with me for a second on emerging economies, the yellow line. You can simply think of India and China in there, ignore all the rest. Oil is the one commodity absolutely essential to their economic growth.

These people want thousands of products we take for granted. They need oil to drive trucks, cars, planes and ships. They need oil to run factories, machines and power plants so necessary to a modern industrial economy. Even a 2% growth in GDP is huge as we are talking about billions of people.

Oil is almost a sure investment because the global market is immense and is still growing. This is without taking into consideration how new supplies of oil cost more to produce and are harder to reach.

How Much More?

How does world consumption look like for the next 10 years? We can take a look at the following graph from the EIA:

To calculate how much more oil we will need 10 years down the road, let’s assume a 1% growth in consumption every year for the next decade, a conservative figure. We are currently producing/consuming about 87 million barrels of oil per day, in 10 years we would need to produce about an extra 10 million barrels of oil per day in order to satisfy the demand. To put it bluntly, we need another Saudi Arabia to fill the gap (current production: 10.8mbod). The graph above takes into account the steady production decline rate of -2% per year which results in a production gap of 25 million barrels of oil instead of 10. Ignoring the decline rate for the sake of simplicity still confirms that a growing market is out there.

So why oil? The immense market and the obvious continuing growth are good enough reasons. Before you get all excited about this sector, just like other investments there are risks associated with the oil sector. The price of a barrel of oil can still go through air pockets in the short term, volatility is to be expected.

The next article will take a look at China who is on its way to surpass the USA in daily consumption.

What do you think dear Reader!  Do you see any holes in the data ? Do you agree or disagree with the conclusion?

14 comments to Investing In Oil: The Fundamentals

  • Good post Mich. Hey, have you read Jeff Rubin’s book?

    http://www.theglobeandmail.com/books/why-your-world-is-about-to-get-a-whole-lot-smaller-by-jeff-rubin/article1148668/

    I think you’d like it.

    I don’t see many holes in your data, and would side you on the fact that we (civilization) will need lots of oil for at least the next 30-40 years. That’ plenty of time for you and me to retire :)

  • Awesome post, Mich, and I really like the graphs. Even if there was a huge commercial breakthrough in solar power tomorrow, it will still take time to shift the economy over, and those huge stocks of hydrocarbons will still be valuable for many materials even then.

  • Mich

    @FC,

    Thanks for pointing out the book, it’s now on my wishlist :)
    Hopefully O&G is the sector to be in in the next 10 years!

    @IW,

    Exactly Kevin, a huge breakthrough tomorrow will lead nowhere in the short term, that’s why i did a case study for the next 10 years!

  • [...] Beating The Index looks at the fundamentals of Investing In Oil. [...]

  • cynical investor

    accidentally came across this article:
    http://www.milliondollarjourney.com/peak-oil-or-oil-bubble-the-oil-bubble-argument.htm

    “9. Many European geologists, especially in Russia, still believe in the abiogenic theory. Oil is widely considered to be a fossil fuel in the West, but this belief is far from unanimous world-wide. The abiogenic theory states that oil is created by carbon released by microbes that migrates upward from the earth’s mantle. It has been popularized in the West recently by Thomas Gold, professor at Cornell University. If it is correct, then not only can oil be continuously created, but there may be far more oil in the earth than most believe. Oil companies have not drilled in areas most likely to contain abiogenic oil. Most geologists consider oil to be a fossil fuel, but the abiogenic theory has not been proven false.”

  • Mich

    Hi Cynical,

    Thanks for dropping by and sharing this paragraph. The theory could be correct, no doubt about that. But there’s better than that, Synthetic fuel generated by transforming coal to oil. In 1944-1945 this was the lifeblood of the German army and one of the reasons they lost the war was the destruction from the air of their synthetic fuel complexes that were producing as much as 124k barrels per day. In the end the best tanks would have to be abandoned and blown up.

    Later on the US was to experiment with this technology in the 50′s until the plug was suddenly pulled out for dubious reasons (think oil interest groups). We need to keep interest groups in mind in capitalist societies.

    Until the abiogenic theory is proven, we are searching in harder to reach places to supplement our supplies, cheap oil has been mostly found and the EIA is forecasting unconventional oil sources to fill up the space ie oil
    sands ($60+ break even cost) etc…

    The electric car won’t be the magic solution in the near term, I have a post about that coming. Can I relatively safely assume that in the next decade oil is on the path of growth? I believe so, and it doesn’t take $150+ prices per barrel to make money, if oil stays in the $70-$90 band, it will be a profitable investment.

    Cheers!

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  • cynical investor

    Mich,

    You mentioned about transforming coal to oil and I remmembered I had a ‘post’.

    http://www.thecynicalinvestor.net/2010/07/coal-to-gas.html.

    Researchers at the University of Texas at Arlington said that they had managed to get gasoline at the price of $30 (If I recall properly as the full article the post was pointing to is locked now).

  • Mich

    Cyncial,

    Interesting i never heard of that. I wonder how much energy is required or what the carbon footprint is for this process.

    I am also amazed at the lack of policies on a national level to decrease the dependency on crude oil. Oh well, where the will is lacking ,there’s profit to make!

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    [...] Investing in Oil: The Fundamentals [...]

  • So this is where it all begins! Great breakdown and supporting evidence as usual. Excuse the novice question, but you say we can invest in oil for the next 10 years, what happens then? Will our finite supply disappear?

    • Mich

      Not at all Buck, one has to evaluate the fundamentals of oil in order to make sure you’re not holding a commodity that is becoming obsolete. We have lots of supplies to be tapped, they just cost more to extract requiring higher prices to make a project economic.

  • [...] are only predictions, I like to stay current with the IEA’s reports as I enjoy confirming my investment thesis in oil. In the short term, at least until 2020, I do not believe our hydrocarbon based economy will change [...]

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