Oil isn't that simple

www.globeandmail.com By MATHEW INGRAM Globe and Mail Update

The price of crude oil has skyrocketed over the past several months, partly as a result of concerns about supply from Venezuela and partly because of market speculation as the United States gears up for a war with Iraq. On Thursday and Friday, crude came within a hair of $40 (U.S.) a barrel, close to the peak it hit after Iraq invaded Kuwait in 1990. So that means investors should run out and load up on oil stocks, right? Not so fast.

Like most heavily traded commodities — such as gold, for example — supply and demand are only part of the equation when it comes to oil prices. The current price, which is hovering in the $39 range, is a result of supply glitches in Venezuela and higher demand for fuel oil in the United States due to cold weather, but it is also driven by an army of commodity traders, and theories about what may happen a month or two from now.

Based on simple supply and demand, the price of crude should probably be in the mid- to upper $20 range somewhere, depending on which market expert you talk to. The rest of the current price is a result of speculation by oil traders about what will happen if war is declared, whether Saddam Hussein will decide to blow up his own oilfields, whether OPEC will be able to deal with any supply disruptions, and so on.

Some traders are betting that a war with Iraq would be over fairly quickly, and that once it is finished the price of oil will return to normal levels. This is based largely on the fact that it's exactly what happened after the Gulf war. Traders betting on that scenario have been short-selling oil, and some of the price rise in recent days has been blamed on short-sellers having to buy to cover their bets.

The opposite end of the spectrum has traders not only betting that the war in Iraq will go on longer than it did in 1991, but also that it might destabilize the rest of the Middle East, which could make the supply of oil from other OPEC producers less reliable as well. The combination of those events has some oil industry watchers predicting that oil could stay above $40 for some time, and might even get to $70 or $80.

The chance of that more extreme version of events taking place is fairly low, most oil industry analysts say. According to Philip Verleger, an oil industry economist and senior fellow at the U.S. Council on Foreign Relations, even if a war stops the flow of oil from Iraq completely, the other OPEC nations — and Saudi Arabia in particular, the cartel's largest producer — will likely step in to help cover that supply.

According to Mr. Verleger's comments at the Institute for International Economics, the oil-producing nations would do this for a couple of reasons, the first being that skyrocketing oil prices would be bad for the global economy — and that would be bad for business in the long run. The other reason is that high prices would encourage non-OPEC nations such as Russia — which already produces almost as much oil as Saudi Arabia — to produce even more, and that would cut OPEC's market share.

But even under a moderate scenario, won't producers enjoy windfall profits, and therefore aren't their stocks sure to go up? After all, Canadian Natural Resources just said its fourth-quarter profit tripled over last year, and it could make $1-billion (Canadian) more in profit this year than it expected to a month ago. Unfortunately, it's not that easy to draw a straight line between higher crude prices and higher stock prices.

Take a look at what happened to Canadian Natural's stock after it made that announcement. You might expect that $1-billion extra dollars on the bottom line, even for a company that size, would make a major difference — after all, it works out to more than $7 per share. And yet the stock rose by less than $3 after the news, and at $50 or so isn't even as high as it was last fall. It has climbed by 25 per cent since October, but the price of crude oil has climbed by more than 60 per cent since then.

"Institutions never pay for peaks, nor do they pay for valleys," FirstEnergy analyst Martin Molyneaux told Globe and Mail reporter Guy Dixon recently. In other words, investors won't pay more for a stock if they don't think high oil prices are sustainable, even though the company might seem to be worth a lot more. The risk that the price increase won't be sustainable translates into a lower multiple for those stocks.

Of course, oil and gas stocks (because most companies do both) have been going up based on more than just crude prices. Natural gas is also high, in part because of cold winter weather, and a sharp drop in inventories. That could help justify higher prices even if crude oil does come back down in price — but it isn't going to produce a windfall for investors at this point, given how far some stocks have already climbed.

E-mail Mathew Ingram at mingram@globeandmail.ca Look for exclusive Mathew Ingram commentary at GlobeInvestorGold