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Dig deeper to find oil's true potential Add to ...

U.S. demand for crude oil may well have peaked about six years ago. Canadian producers that supply the once-insatiable American energy hog are watching their stocks crumple, in part because investors are terrified by this drop in demand.

But the market is probably being too gloomy. Battered oil stocks are starting to get interesting again. Their turnaround is unlikely to be quick, but at their current valuations, they represent a good opportunity for investors who are willing to overlook what at first glance appears to be a daunting list of problems.

The immediate difficulty is U.S. unemployment. Most of our oil is shipped south where the bulk of it ends up in gas tanks. The jobless drive less than half as much as the employed. And because U.S. unemployment is so persistently high, there’s little chance of a rise in demand from south of the border. Oil consumption rose last year for the first time since the peak in 2005, but that replaced less than half of the million barrels of daily consumption lost since mid-2008.

Appetite for oil is now slumping once again – the U.S. Department of Energy sees demand falling this year – and it looks like this latest drop could be permanent. The U.S. consumer is tapped out and driving less. On top of that, new regulations are going to crimp demand even more. The use of renewables such as ethanol is mandated to increase to 36 billion gallons in 2022 from less than half that today. And fuel economy standards are also more than doubling by 2025.

The trends point to stagnant, if not falling, demand in the United States and the West in general. Demand could rise from the recession-like levels of today, but the long-term outlook is bleak (which, of course, is a good thing in other ways).

To make matters worse, softening consumption is accompanied by a surge in supply. The Gulf of Mexico has been bountiful, as has the tired old Western Canadian sedimentary basin. Most of our oil goes to Cushing, Okla., but it’s piling up at the refineries, which understandably aren’t bidding for barrels very aggressively, hence the big discount between North American and foreign prices.

There’s good news, though. First, demand for oil in developing countries will offset declines in our world and then some, given their economic growth and populations.

The United States still matters a lot: It accounted for one-sixth of last year’s global increase in demand. But every year it matters less. China is the globe’s No. 2 consumer but, on a per capita basis, its consumption is only about 10 per cent of that of the U.S. When that hits 20 per cent, owing to China’s huge population, the countries will be neck and neck. It only took about 10 years for Chinese per capita demand to double to where it is now.

The Arab Spring is also a boon for those who want higher prices. Saudi Arabia has a lot of young people. The kingdom will have to throw them some bones to keep them from getting restless and that means extracting more revenue from the country’s oil resources. The new Libyan regime would also like higher prices. So the Organization of Petroleum Exporting Countries has an incentive to keep prices high.

And finally, pipelines will help solve the discount problem dogging North American oil. TransCanada’s proposed Keystone XL line, which will take oil from Alberta to the Gulf Coast, where it fetches a higher price, is tied up in the usual wrangling between politicians, environmentalists and businesses. But given the jobs the multibillion-dollar project would create, it’s hard to imagine the project being denied. (A decision is expected before year end.)

Enbridge is also looking at building more capacity from Cushing to the coast. And, for those of you who like long shots, there’s the Northern Gateway pipeline proposal that would take crude over the mountains to the Pacific, where it could be exported to Asia. These lines would take a long time to build but stock markets look ahead.

The old adage that says successful investors are realists who buy from pessimists and sell to optimists applies very well to energy stocks. A good strategy is to keep top quality oil names in your portfolio, and add to your positions when pessimists rule and lighten up when the optimists come back.

It looks like the pessimists are in charge today. Consider Imperial Oil , a stock I own and follow. Insiders are buying, and apart from a very brief plunge in 2008 it hasn’t been much lower than where it is today in many years. It has certainly been higher.

The parent company, Exxon Mobil , is also interesting. It’s benefiting from higher international prices, so its earnings are going up.

U.S. consumers are still important to energy markets, but their importance has peaked. Investors should focus on the broader picture. That’s where they’ll find the opportunities.

Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. He can be reached at fabrice.taylor@gmail.com.

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