The Slippery Math of Pricing a Barrel of Oil

It seems that every day, local and national news headlines harp on rising energy prices. That’s not surprising, considering that a barrel of oil now costs 9% more this year, and gasoline has followed suit.

As global demand continues to rise, exploration and production (E&P) firms have had to look toward unconventional sources in order to keep supplies coming. These assets are often located in remote areas of the world and require complex drilling techniques to access the hydrocarbons. All of this costs major amounts of money, and ultimately the costs get passed down to the consumer.

Exxon’s (NYSE: XOM) CEO Rex Tillerson remarked when he unveiled his company’s massive capital spending program: “The cost per barrel clearly is going up, with the size, the magnitude and the conditions with which we’re making some of these investments.”

However, while the cost of production certainly plays a major part in the price of oil, it’s not the only thing. Plenty of other factors help determine the price of crude. For investors, knowing how these factors affect the energy sector is important and could lead to opportunities.

Speculation, Geopolitics and Demand! Oh My!

The cost of pumping a barrel of oil out of the ground depends on several things, including the size and accessibility of the field. While it’s certainly harder and more expensive for energy companies to pull oil out of the earth these days, that cost of production is still only part of story.

Oil companies are often reluctant to give precise cost information, but analysts peg average costs in the neighborhood of $80 per barrel for the U.S. benchmark West Texas Intermediate (WTI) crude and about $94 for the European benchmark Brent. That’s still more than $20 below each of these benchmarks’ current spot prices.

So what accounts for that difference? A dash of speculation and a handful of geopolitics.

The speculation aspect can be summed up based on a rising demand picture. Overall, as the global economy has begun to recover, demand for crude oil is rising and likely to keep doing so. Increasing industrial production, expanded transportation and overall economic growth require vast amounts of energy to get going. Investors are betting that in the short term, demand will outweigh supply and push prices higher.

Investors are also making the same bet longer term. As emerging markets like China and Indonesia continue to urbanize and see widespread population growth, the general presumption is that their energy demand will skyrocket. Automobile ownership in China is estimated to rise by 10% in 2012 and continue growing to 300 million units by 2015. These sorts of growth prospects will only lead to higher sustained oil demand over the future.

It’s easy to understand the future demand facet being priced into oil. The geopolitical side is where it gets a lot trickier. Currently, much of the rise in oil prices stems from conflict in the Middle East. Tensions between the West and Iran about its nuclear program could be finally coming to a head. Iran has continually repeated threats about closing the Persian Gulf’s vital Strait of Hormuz in response to rising economic sanctions.

While Iran exports only around 2 million barrels of oil a day, the Strait of Hormuz is a critical shipping passage for the world’s energy market. The U.S. Energy Information Agency estimates that around 17 million barrels of oil per day passed through the Strait during 2011.

These worries over Tehran have caused Brent prices to increase nearly 17% so far this year. While energy analysts predict that Iran won’t take military action, the odds are rising that it will. Located on the opposite bank of the Strait, fellow OPEC member Oman recently said the risk of military conflict between Tehran and the West was rising exponentially. One wild card is the chance that Israel would launch a strike at Iran’s nuclear facilities. The Jewish state hasn’t ruled out that option, yet.

Couple this with last summer’s uprising in major oil producer Libya — plus the recent internal turmoil in Syria, Yemen and South Sudan — and you have a recipe for serious supply shocks. Analysts at Morgan Stanley (NYSE:MS) predict that any blockage of the Strait will cause a $40 leap in the price of Brent crude. And that’s just one guess.

Playing the Oil Price Breakdown

With production costs steadily rising as E&P firms keep tapping more unconventional sources, these sorts of geopolitical issues will always produce a premium on the price of crude. While it’s conflict in the Middle East this month, next mont could see some other issue. Understanding where this premium lies is key for investors.

I’ve written several times before about how the oil service industry remains one of the best ways to play rising production costs. My favorite fund in sub-sector, the equal-weighted SPDR S&P Oil & Gas Equipment & Services (NYSE:XES), continues to have all the characteristics of a long-term winner. Pairing it with a more broad energy-focused fund like the Vanguard Energy ETF (NYSE:VDE) makes a great way to overall play on rising demand and energy prices.

Playing the short-term and fluctuating geopolitical premium can be achieved via the Direxion Daily Energy Bull 3X Shares (NYSE:ERX). The fund is certainly not a buy-and-hold investment, but it can be used tactically to gain from short-term price interruptions. So far the fund has surged in the face of the Iran news and could gain more if the scenario leads to conflict.

However, this ETF becomes a sell if things begin to smooth out. For those willing to do a little trading while holding a more long-term position in the previously mention ETFs, the Energy Bull fund could be a great addition to portfolio.

As of this writing Aaron Levitt is long XES

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