Why $100 Oil Is the New $80

Since spiking back in January, the price for West Texas Intermediate (WTI) crude oil has roughly bounced between $100 and $110 as a slew of factors have kept prices elevated.

The global-standard Brent seems to be caught in a similar trading range as well. With such price floors in place, many energy investors are now wondering if $100-per-barrel oil is the new $80 oil?

Rising demand in a variety of emerging-market nations certainly is a major factor in global oil prices. As it is, production costs for E&P companies are steadily rising as they tap more unconventional sources to meet that demand. But that’s just one piece of puzzle.

The truth is that the U.S. is currently awash in oil. Advanced horizontal drilling techniques and the widespread adoption of hydraulic fracturing in rich shale fields such as the Bakken have unlocked an abundance of energy.

Stockpiles in the U.S. have risen to an 11-month high of 371.7 million barrels, and analysts predict that the number will rise over the course of the year. With such deep reserves, say a variety of analysts, a huge dip in prices is in store.

So what gives — and why is $100-per-barrel oil the new price floor? It’s all about geopolitical risk.

Given the U.S.’s abundant supply and dwindling demand picture, analysts predict that WTI oil prices should be closer to the $80-to-$85 range. When we last looked at the metrics behind pricing a barrel of oil, geopolitical tensions played a major part in determining that price. Well, the more things change, the more they stay the same.

Tensions with Iran continue to play out in the global energy markets, with the nation’s uranium-enrichment program at the center of the dispute. The OPEC member continues to deny allegations that it’s trying to build nuclear weapons and says it produces uranium to fuel nuclear reactors.

Because of concern that Iran is developing nuclear weapons that could strike Israel or other potentially sensitive targets, the U.S. and the European Union have imposed a variety of economic sanctions. But since Iran has been defiantly displaying its nuclear achievements, policymakers are considering even tougher measures.

At the same time, in response to the economic punishments, Iran has continually repeated threats to close the Persian Gulf’s vital Strait of Hormuz. The six-mile gap is major throughway for a variety of goods, and its closure could result in about a 20% reduction in the world oil supply.

As a major supplier to the world — Iran produces about 2.5 million barrels of oil equivalent a day — the recent sanctions have wreaked havoc on oil prices, causing a 15% to 20% price premium on cost per barrel. That premium isn’t unwarranted.

Iran is the third-largest exporter of crude (behind Saudi Arabia and Russia), and it was one of the original Gang of Five nations that founded OPEC in the 1960s. The nation has historically moved the energy markets — either a boycott of Iranian oil or an Iranian refusal to export oil has the same outcome: falling supplies and rising prices.

Already, the recent sanctions have caused Iran’s production to drop. According to an OPEC report, Iranian output fell to 3.35 million barrels in March from 3.46 million in January.

Iran seems to be “playing nice,” meeting with six world powers, including the U.S., England, Germany and Russia this past week. While the results of those talks won’t fully be digested until the group reconvenes at the end of May, analysts have already speculated that if worries about Iran disappear, oil will drop lower — to the previously mentioned $80-to-$85 range.

I wouldn’t hold my breath waiting for that to happen.

Political instability in the Middle East will continue to be major problem. Before the recent Iran issues, it was Libya. Before Libya, it was Egypt. Other uncertainties focus on civil unrest in Yemen and discord between Sudan and South Sudan.

Meanwhile, Syria continues to erupt into violence, and Tunisia has stated its support for Iran’s positions on nuclear power and the Strait of Hormuz. The latest blow could be Egypt’s decision to halt a natural gas supply agreement with Israel, which could fuel Middle East geopolitical tensions. Israel’s Finance Ministry said the nation views “the termination with great concern and warned that the step could damage peace agreements between the countries.”

And here in the U.S., poor infrastructure is preventing that glut of oil from reaching critical refiners. While there are plenty of proposals for new pipelines and reversals of flows, adding capacity takes months, if not years, to complete.

Even accessing that glut could still result in higher prices. Enbridge’s (NYSE:ENB) planned Seaway Pipeline reversal and TransCanada’s (NYSE:TRP) expansion of the Keystone XL pipeline could see WTI prices converging on Brent as WTI once again becomes a world benchmark.

Already, the spread between the two standards has decreased simply on the news that these pipelines are planned and currently sits at around $16. That’s the lowest that spread has been since February — and far below the record of $26 reached in August.

So while an end to Iranian tensions should allow prices to dip in the short term, there are plenty of reasons why they’re sure to move higher again down the road. Political instability in the Middle East will remain a price-boosting issue, most likely for years to come.

Rising production costs due the industry’s increased reliance on unconventional sources of supply and growing global demand will also keep WTI prices relatively high for the reasonable future. Odds are we won’t see $145-per-barrel crude anytime soon, but the $100-to-$110 range is certainly doable.

I’ve written several times about the importance of having energy investments in one’s portfolio. My favorite funds in this sector continue to be the equal-weighted SPDR S&P Oil & Gas Equipment & Services (NYSE:XES), the broad and cheap Vanguard Energy ETF (NYSE:VDE) and U.S.-focused iShares Dow Jones US Energy (NYSE:IYE). These funds have all the necessary characteristics of long-term winners.

Pairing any of them with one of the major pipeline companies, such as Enbridge or Kinder Morgan (NYSE:KMI), would make an ideal way to play oil’s new price floor and rising global demand.

Aaron Levitt is long XES.

Article printed from InvestorPlace Media, https://investorplace.com/2012/04/why-100-oil-is-the-new-80/.

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