We’re well on our way to $200 oil. Are you ready?

Over the course of the next six months, major changes are going to shape our economy… The only one you should care about is the price of oil. Turn on CNN, Fox News, or CNBC, and you’re all but guaranteed to see a panel of “experts” who are betting on cheap oil. They’re making a huge mistake.

Now more than ever oil is poised to rocket back up to triple-digit prices – and the investors who make smart bets now are going to make a fortune in the process.

Americans are getting misled about the oil crisis that we’re really facing. Despite media contortions that suggest speculators in the futures market are responsible for the monumental price swings in oil that we’ve seen in the last two years, the price of oil isn’t in line with where it should be right now. It’s absolutely true that oil speculation fueled oil’s run-up to $147 last summer, but what the pundits leave out is the fact that oil’s intrinsic price is on the rise regardless of supply and demand.

Prices that aren’t based on supply and demand… What kind of market is this?

The Real Reason for Rising Oil Prices

One of the reasons is the fact that the cost of extracting and processing oil has been rising over the course of the last few years. Peak oil is a frequently mentioned justification for the growing cost of oil extraction. Under the peak oil theory, as we pump the good, easy to find oil out of the ground, we’re left with lesser quality oil that’s deeper in the earth and more difficult (and expensive) to extract.

But peak oil isn’t just a theory; it’s a certainty.

Some oil experts even believe that oil may have peaked back in 2005. If that’s true, it means that as time goes on the price of oil will continue to climb very quickly. That said, the evidence that worldwide oil production has already peaked is anecdotal at best.

The chart above shows worldwide oil production from 1960 to 2005. While crude oil production reached new highs in 2005, we’re currently in a place similar to the late 1970s where oil saw a short-term “false peak” then continued to climb. And for every expert that says we’ve already hit oil’s production peak, there are two that say we have reserves to last us decades more, and that the peak is a long way off.

But that doesn’t change the fact that the cost of oil is rising for producers.  Could it just be a case of poor budgeting?

Right now, a handful of Middle Eastern nations are in a tight spot. Despite access to one of the most precious commodities in the world, places like Saudi Arabia, Dubai, Qatar, and Oman are at serious risk of posting big budget deficits for 2009. For some, like Saudi Arabia, it would be the first deficit posted in almost a decade… For others, like Qatar, this would be the first budget deficit in the country’s history.

And over spending isn’t relegated to the oil producing nations… oil producing companies are feeling the hurt as well right now:

In the last nine months, oil giant ExxonMobil (NYSE: XOM) saw its profits drop 73% to $0.92 per share. That’s a colossal tumble for a company that just a few months before announced the he largest annual profit of any company in U.S. history.

Before the oil boom took off, the operating cost for extracting a barrel of oil was $38. In the last several years, the bottom line break-even price for a barrel of oil has averaged $87.24 – that means that in order for companies like Exxon and Chevron to report a profit from their oil production divisions, they need to see oil prices 22% higher than they are now.

But it gets worse…

Between 2002 and 2008, oil prices rose steadily – at a rate of nearly 18% every year. With projections of $100 oil in the late 2000s (like we saw last year), oil companies and producing nations grew their obligations, building new facilities and spending nearly 60% more on exploration of new oilfields. Those huge expenses are going to have to be priced into each barrel of oil going forward, raising breakeven costs even more.

Why High Oil Costs Mean High Oil Profits for Investors

Even though the cost of oil (and its intrinsic price) has little to do with supply and demand, those two market forces are more or less what drive the market price of oil. In the past year, we saw oil prices fall as far down as $33.87, a painful spot for the oil companies and producing nations that I mentioned earlier.

As long as making a profit on oil continues to be difficult for companies, we’re going to see the playing field contract. Middle Eastern countries will have two choices: tighten their belts and cut spending, or pressure OPEC to cut production and increase their margins.

Make no mistake – high oil prices aren’t going to throw our country into anarchy. We’re not facing disaster at the return of $150 oil. But oil prices must go up, and many investors are just starting to realize it. Those who do are going to find their portfolio values go up as well.

I’ve found an ETF play that is poised to capitalize on the rising cost of oil. In fact it’s set to take off in the next week. That said, it’s not quite time yet – I’m hoping for a healthy dip before we go in for a buy. I’ll be back Friday with the ticker and the reason why it’s the only oil ETF you should bother with.

Remember, I’m releasing this recommendation exclusively to Penny Sleuth readers this Friday…

Cheers,
Jonas Elmerraji

August 5, 2009

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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