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October 22, 2009

·         $80 oil

·         Herman E. Daly on the economics of limited resources

·         Profiting from oil and gas small-caps

Fellow Investor,

Yesterday, oil rallied to close above $81 a barrel, the first time the precious commodity has hit that level in 2009.  Oil prices gained momentum after the U.S. government released a report showing that crude inventories rose by half a million barrels fewer than expected.   

The rise in oil prices, and many other commodities prices for that matter, has many wondering if the market is too bullish given that economic growth is uncertain.  Plus, much of the rise in oil has come on the back of a falling dollar.

You’ve probably heard that renewably energy sources like wind and solar will reduce the demand for oil. Government programs that incentivize their use have worked in places like Brazil.  But overall, they haven’t slowed the relentless rise of oil prices.

While these factors might make the rise in oil prices seem unsustainable, it’s more likely that normal supply and demand relationships will resume when the economy gets back on track. In other words, higher prices are coming. Peak oil (the point when the world reaches a maximum rate of petroleum extraction, after which production will always be declining) adds an interesting dimension as well.  Some experts think we’re past this point, some think it won’t arrive until 2020.

The bottom line is this: Oil is going higher.  It might not be tomorrow, it might not be next week, but its upward trend is unmistakable. 

One of my favorite authors on the economics of limited resources is Herman Daly.

Herman E. Daly was a Senior Economist in the Environment Department of the World Bank before he became a professor at the Maryland School of Public Affairs.  You may be familiar with him from the journal, Ecological Economics.  He is co-founder and associate editor.

Daly eloquently lays out a bullish case for scarce resources, such as oil, that is difficult to deny. He points out that there’s absolutely no way we can generate more fossil fuels.  We’d have to be immortal and extremely patient, because it takes several million years for geological forces to “make” new oil supplies.

One of the beautiful things about properly functioning markets is that they efficiently allocate resources.  However, markets don’t determine sustainable scale.  In the U.S., for example, individuals use more oil than we need to. In China, on the other hand, smaller vehicles and less driving time mean each individual is essentially rationing his or her use. Oil use in the U.S. is practically a cultural truth. And it would take government action to change it. Governments the world over are not rationing use of fossil fuels. 

Daly notes that we can’t control the supply of oil, but we could control our rate of use. Unfortunately, the government isn’t taking the lead in either case. 

Whether you think we are near, at, or past peak oil is irrelevant.  Oil is becoming increasingly scarce and the rate of adoption of alternatives is nowhere near strong enough to replace the increasing oil demand.  The discrepancy is more exaggerated in emerging markets then it is here in the U.S.  Investors will continue to put a premium on oil.

I’m bullish on oil.  And small-cap oil stocks can be expected to outperform the big integrated oil companies. As the price of oil goes higher, oil that’s not economical at lower prices suddenly becomes attractive.  Valuations for small companies can change quickly. 

Today, there are a number of oil and gas companies that we’ve discussed in recent issues of SmallCapInvestor Daily that are trading lower.  I’m talking about stocks like American Oil and Gas (AMEX:AEZ), Pioneer Drilling (AMEX:PDC), Abraxas Petroleum Corp (Nasdaq: AXAS), RAM Energy (Nasdaq:RAME), Rex Energy (Nasdaq:REXX) and Tri-Valley (AMEX:TIV). They’ve had a nice run in the last 3 months. And they will likely move higher in the future.

We’ve discussed the oil and gas sector regularly, and I will continue to watch it in the future.

Until tomorrow,

Ian Wyatt

Editor

Daily Profit

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