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?