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Will $200 oil kill the economy?

March 2, 2011


Unrest in key oil-producing nations opens the door to price spikes that could push gas to $7 a gallon and spin the world back into recession. Here’s how we’d get there, and how to protect your portfolio.

Image: Oil drums © Kevin Phillips, Digital Vision, age fotostock

Are your pocketbook and portfolio ready for $200-a-barrel oil?

This kind of dramatic price spike may seem less likely now than a few days ago, with oil markets calming down a bit and the price slipping below $100. But given the instability and unrest rolling through the Middle East and North Africa, it’s a definitely a viable scenario.

For the moment, most oil sector analysts have gone off high alert because of a Saudi Arabian pledge to increase production to make up for any shortfalls sparked by unrest. But that ignores a key angle in all this: There’s simply not enough spare capacity to make up for the production losses we’d see if the rolling crises in the region hit just two or three major producers at once.

This could easily happen, given the heightened potential for instability in four significant producers: Iran, Iraq, Kuwait and Algeria. Meanwhile, few analysts are even talking about Nigeria, but they should be. April elections there could bring attacks on the oil production infrastructure, just as happened in the previous two elections.

In a moment, I’ll walk you through the details of how easily we could get to $200 oil, which would push gas to $6 or $7 a gallon at the pump. First, let’s consider what a disaster $200 oil would be for our fragile economy.

Nowhere to hide

To sum up, it wouldn’t be pretty. A sustained hike in oil prices to around $200 would definitely derail the economic rebound.

Here’s the simple math: Because every $10 rise in oil prices reduces annual U.S. gross domestic product growth by 0.2%, a $100 increase in oil would knock down growth by at least two percentage points, says Nigel Gault, the chief U.S. economist of IHS Global Insight. With the economy growing at just 2.8%, that would put us back near recession. He says the effects of $200 oil would probably be bigger, since we would be in “unknown territory” with energy prices that high. Gault is not alone in this view. “In all likelihood, we will be back in recession if we go to $150 and stay there for a month or two,” says Mark Zandi, the chief economist at Moody’s Analytics.

Here’s another problem: A big spike in oil prices would bring more inflation at a time when the Federal Reserve doesn’t have a whole lot of leeway to combat inflation by raising interest rates.

Prices at the pump would shoot up to around $6 a gallon, since each $10 increase in oil prices translates into a 25-cent increase in gasoline prices. The national average is around $3.30 a gallon now. A crisis premium on top of that — say, worry that another oil-producing nation experiences a revolt — could take gas prices to $7 a gallon.

Economy: Shock & Oil

That’s not quite the $10 a gallon you might have heard talk-radio hosts fretting about last week, but it would have huge economic implications. Prices of just about all goods would go up, because shipping and manufacturing would cost more. And of course, oil touches almost every industry we have, from plastics production to agriculture.

In the stock market, there would be almost nowhere to hide. Automakers, truckers, airlines, manufacturers and travel-related industries such as hotels and restaurants would get hit hardest. Most retailers, even high-end stores, would suffer, too. Consumers with moderate incomes would see their budgets hurt by higher energy costs, of course. But the stock market crash would make high-income consumers close their wallets, because they have so much of their wealth in stocks. About the only kind of stores that might benefit would be low-priced retailers like Wal-Mart Stores (WMT, news) as consumers turn to them for discounts, trading down from more expensive retailers.

Now, I’m not suggesting you sell all your stocks and empty your 401k because of the possibility of $200-a-barrel oil. Even if it reaches $200, oil can’t stay that expensive forever. Energy-rich countries need the income from oil, so however the uprisings come out, they would figure out a way to get production back on line. And at worst, $200 oil would kill growth to such a degree that demand would plummet, driving oil prices back down.

But it does make sense to get more exposure to energy stocks right now, particularly those of the oil-service sector companies that provide the equipment and know-how for finding and producing energy. These companies, like Schlumberger (SLB, news) and Transocean (RIG, news), will do well in a price spike, and they’re likely to do well over the next several years anyway. Natural declines in production at existing sites means energy companies will have to keep finding and develop new supplies.

The $200 oil scenario

To understand how we could get to $200 oil in a hurry, you need to start with two key facts that provide a big-picture perspective.

  • World oil production is about 88 million barrels a day, with about 5 million barrels a day worth of spare capacity.
  • During the Gulf War in the early 1990s, it took only a 2.1-million-barrel-a-day decline in spare capacity for oil prices to skyrocket 130%, the equivalent of oil reaching $220 a barrel today, points out oil sector analyst Michael Lo of Nomura.

Next, it helps to take a quick tour of the major oil-producing countries in the Middle East and Africa that face domestic turmoil. For help with that, I turned to Charlie Maxwell, a veteran energy analyst with Weeden, and other energy analysts.

  • Iraq: Religious and regional factions have been at odds here for centuries. Those tensions could boil over into terrorism, bombings and attacks on the energy infrastructure as U.S. troops leave. U.S. troops are moving out now in phases, and they are scheduled to leave completely by December. “The worst scenario is that Iraq cannot settle down, and the peace dissipates when our troops pull out,” says Maxwell. Total potential oil production at risk: 2.7 million barrels a day.
  • Iran: In addition to the domestic political unrest that’s often near a boiling point, there’s a cross-border risk as well. Iran’s nuclear program has the potential to spark a military confrontation if there is evidence the country is pursuing nuclear arms aggressively. Total potential oil production at risk: 3.7 million barrels a day.
  • Kuwait: In this country, we see the kind of domestic political unrest and resentment toward a ruling family that helped topple regimes in Tunisia and Egypt. “We’ve got a full head of steam here,” says Maxwell. Plus Kuwait’s energy assets would be a “very big prize” for terror groups that might like to take them over as a revenue source. On top of that, Kuwait’s armed forces are small and not well trained, says Maxwell. Total potential oil production at risk: 2.3 million barrels a day.

“Those are the three that I would worry about,” says Maxwell. A decline of just 50% in these top three at-risk countries would send global spare capacity down to levels that contributed to the 130% price increase during the Gulf War. But we’re not done with our tour of the worst trouble spots yet.

  • Algeria: In Algeria, secularists are battling Islamic extremists for control of the country, and there have already been terrorist threats on the energy infrastructure as part of this dispute. Algeria is a significant producer, at 1.3 million barrels a day.
  • Nigeria: Few talking heads on TV are discussing Nigeria, even though it, too, presents a growing risk as elections approach in April. The last elections, in 2003 and 2007, brought armed violence among political factions that included attacks on the country’s energy infrastructure. “The elections could be particularly tumultuous in the oil region,” says Helima Croft, an analyst with Barclays. “The 2011 elections could prove more volatile than previous polls, because there are deeper divisions within the Nigerian political elite than during the 2003 and 2007 campaigns.” Nigeria is also a significant producer, at 2.2 million barrels a day.
  • Libya: There’s no guarantee that Libya will get back up to its full 1.6-million-barrel-a-day production any time soon, even if Muammar Gaddafi is ousted. “After dictators, the good days do not roll,” says Maxwell. Instead, Libya may see a phase of prolonged battles among tribal groups and other factions, which could keep energy production well below full capacity. Paolo Scaroni, the CEO of Italian energy company Eni (E, news), estimates that Libya’s output is down by 75% as energy companies remove personnel and shut in production.

All of this means the risk of much higher oil prices — even up to $200 a barrel — are quite real, in my view. Following are some ways to position your portfolio for an oil price spike.

Oil service stocks

One relatively safe way is to buy the stocks of companies that sell the drilling equipment, boats and consulting services that help energy companies extract fossil fuels. These stocks will do well in an oil spike. But even if we don’t see one, these stocks look like good medium-term investments because of the ongoing need for more spending on energy development over the next decade.

Barclays analyst Tim Whittaker thinks exploration and production spending will increase by a healthy 11% this year and will nearly double over the next decade. This is one reason he’s telling investors to buy oil service companies like Schlumberger and Halliburton (HAL, news) now, even though they have been strong in the past year. “We expect them to continue their run, driven higher by an increase in upstream capital spending,” says Whittaker.

Brian Hicks, a co-manager of the U.S. Global Investors Global Resources Fund (PSPFX, news), agrees these stocks are good long-term holds. “We have positioned our fund pretty heavily into oil services. We think that higher oil prices are here to stay and production will expand,” says Hicks, whose fund was the top-performing global natural resources fund in 2010, according to Lipper. “There’s going to be a real push for further investment in the oil sector.” In addition to the two companies above, he also likes Transocean (RIG, news), Ensco (ESV, news), SeaDrill (SDRL, news) and Baker Hughes Incorporated (BHI, news) in this space.

T. Rowe Price New Era (PRNEX) manager Tim Parker puts engineering and construction companies McDermott International (MDR, news) and Fluor (FLR, news) on this list as well, because they help build oil and gas infrastructure.

Politically safe producers

North American energy producers like Whiting Petroleum (WLL, news), Swift Energy (SFY, news), Apache (APA, news) and Occidental Petroleum (OXY, news), are good ones to own in an oil price spike for two reasons, says David Streit, who covers energy stocks for Thrivent Financial for Lutherans.

First, since they operate in North America, they don’t face the same political risk that oil companies operating in the Middle East do. The latter may be forced to curtail production for significant amounts of time due to unrest.

Second, big international oil companies don’t actually enjoy the full benefit of higher energy prices. That’s because a lot of the energy reserves around the world are held by governments, which negotiate deals that give them most of the upside when oil prices move much higher.

Guinness Atkinson Funds’ Tom Nelson puts Canadian oil sands plays Suncor Energy (su, news) and Imperial Oil (IMO, news) on this list as well.

The opposing view

Not everyone thinks there’s much of a chance that we will see $200-a-barrel oil. One big potential obstacle is what economists call “demand destruction.” This means that if oil moves that high, it will kill off demand so fast that prices will come back down quickly, says Nelson.

Others question whether enough production will really vanish to make $200-a-barrel oil happen. “As long as the United Arab Emirates, Kuwait and Saudi Arabia remain stable, it’s going to be unlikely that oil will shoot up to those levels,” says Parker, at the T. Rowe Price New Era Fund.

But then again, we’re definitively in a new era, in the Middle East and North Africa. After all, few market commentators — myself included — predicted the ouster of longstanding regimes in Egypt and Tunisia when they wrote their 2011 forecasts in December. So it still seems like just about anything could happen next.

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