How High Can Oil Go?

By Marin Katusa, Chief Energy Investment Strategist

Do you believe in gold – not just as an investment, but as a currency?

Do you believe that nonstop central-bank money printing and manipulation will destroy fiat currencies and send gold soaring?

If so, ask yourself this question: why will the world need all that gold? If gold replaces dollars, yen, euros, pesos, rubles, and yuans, what will governments buy with their gold? They will buy the bare necessities: essentials such as energy, food, and resources to develop infrastructure.

The item at the top of that list is oil. We need oil for everything, from the screen you are looking at to the jet fuel in a B2 bomber. From plastic cups to skyscrapers, our world depends on black crude.

Simply put: If you believe in gold, you should also believe in oil.

The argument that gold would become the world currency when paper currencies become worthless is well understood and frequently discussed in our sister reports. But at the end of the day, gold will be just another currency people use to buy the resources we need to survive. What is important to realize, however, is that those resources are also becoming less accessible. Like gold, these are real commodities that cannot be generated by a printing press – oil has to be pumped, iron ore has to be mined, wheat has to be grown.

As the world's population climbs, there is more and more competition for each barrel, ton, and bushel of these staples. The competition is amplified because natural resources are becoming harder to find and more expensive to produce. As this race for resources intensifies, resource valuations will rise right alongside gold.

In that light, let's consider a world where gold becomes the global reserve currency. What would happen to the price of oil?

$200 per barrel? $300? Or even higher?

Gold's Potential Rise

Let's play a mathematical exercise. We think gold and oil are primed to go higher in the long term. As two of the world's most highly sought-after resources, gold and oil have related valuations. That means that we can use gold forecasts to estimate just how high oil might go.

Gold enthusiasts the world over have churned out countless predictions of just how high gold might go. For our gold statistics, we turn to our Casey cohort from BIG GOLD, Jeff Clark.

Jeff based his calculations on the gold-price run of the late 1970s. For most gold investors, this was the quintessential gold bull market. Prices climbed from just $35 an ounce in 1970 to $850 by January 1980 – a remarkable 2,330% gain. Using the CPI-U to adjust for inflation, that high translates into a gold price today of $2,330 per oz.

We all know that the CPI is a poor measure of real inflation, kept artificially low through Fed manipulations. For a more accurate measure of real inflation, we turn to John Williams' Shadow Statistics. Using Williams' inflation index, the 1980 gold peak of $850 would today represent a peak price of $15,234 per oz.

To use another gauge, let's apply the same percentage gains that occurred in the 1970s bull run to today's prices. From its 1970 low to its 1980 high, gold rose 2,330%. If we assume that gold's current run started in 2001 and apply that same gain, we get a gold price of $6,227 per oz.

Let's also use a slightly less reasonable – but still possible – number. The United States has approximately 262 million ounces of gold in its treasury. M2 money supply is arguably the best measure of the amount of readily available cash in the US economy; it currently stands at just above $10 trillion. Dividing one into the other give a gold valuation of $38,168 per ounce.

Is that completely out of the question? I would say "no." As the citizens of Germany in the waning days of the Weimar Republic learned, the actual price of gold in local currency terms can rise astronomically, and in a very short period of time.

Turning Gold Predictions Into Oil Prophecies

Anyone who believes that the days of the dollar are over and the dawn of gold is imminent believes that gold is set to rocket up in value.

Similarly, anyone who analyzes the global oil scene knows that oil is becoming harder to find, riskier to develop, and more difficult to produce, while Chindia and the developing world constantly demand more oil. That equation has only one result: oil too is becoming more valuable.

To keep things simple, let's assume that oil and gold keep apace in their ascents – they both gain in value at about the same rate. That would keep their valuation ratio at its current level, which is roughly 16 barrels of oil to one ounce of gold.

And now we come to it. We have a set of gold-price predictions, and we have reason to believe that gold and oil will maintain their relative valuations. That means we can apply our 16:1 ratio to our gold price predictions to churn out some big-picture oil-price targets.

Let me be clear: I do not think oil is going to $1,000 a barrel anytime soon. But do I think it's a possibility in my lifetime? Absolutely.

People today are almost obsessed with oil price movements. An outage in the North Sea can boost prices by dollars in a day; news of increased US stockpiles can push them right back down again. Economic stagnation in the world's biggest economies has pundits bemoaning the short-term outlook for oil… but if the price of oil is heading up, up, and away in the long term, why worry about such minor fluctuations?

Regardless of whatever tremors the short term may bring, oil makes the world go 'round. You need it, I need it, the other seven billion people on the planet need it, and every day it is more expensive to get it out of the ground. That might mean more expensive gasoline at the pumps, but with the right investments you won't need to care – your portfolio will cover that and much more.

As oil prices climb, oil explorers and producers alike will see their shares climb much higher. That's just what high oil prices do – they ignite smoldering tensions between national oil companies and international oil firms and between nations competing to secure limited resources. Those tensions turn into a race: who can spend the most money the fastest to lock down access to oil (as evidenced by the escalating competition over oil between the US and China)?

And the main beneficiaries? Investors with the right picks in their portfolios.

The global resource race is already on – and the US already finds that her enemies are at the gates: China, Japan, Korea, and Malaysia are all snatching up oil and gas projects in Canada. Even one of the US's most steadfast allies, Israel, is cozying up to the Russians.

This race for resources is the cornerstone of my investment outlook. Stripped to its fundamentals, it is an argument of simple math:

High prices create hot markets, and oil is heating up. The transition will take time, and the ride will at times be rocky, but the crisis will create fantastic opportunities for attuned investors. Keep your ear to the ground and your eyes on the prize – a future priced in gold and oil.

And that, my friends, is why the future is so exciting for investors in the energy sector who are in the know.

Additional Links and Reads

Activists Up Ante in China, Japan Isle Dispute (Seattle Times)

An unauthorized landing by Japanese activists on a tiny island claimed by Japan, China, and Taiwan has ratcheted up tensions in the already-simmering East China Sea. The landing has put the islands – known as Senkaku to the Japanese and Daioyu to the Chinese – front and center in one of the biggest territorial flare-ups between the two Asian giants in years. National pride is one factor, but resources are just as important: a claim to the islands would bestow rights to the rich fishing and deepwater oil and gas in the region.

CNOOC Cuts Dividend to Make Room for $15-Billion Nexen Buy (Financial Post)

Facing a first-half net profit that fell by almost 20% – twice what the market had expected – and a $15-billion payout to close its acquisition of Canadian oil firm Nexen, China's leading offshore oil producer CNOOC just slashed its dividend by 40%. With just nine years' worth of oil reserves on its books, CNOOC needs to seal the Nexen deal, as the acquisition would boost its reserves by 30% and its production by 20%. But the Chinese giant is struggling to cut costs as it moves further into the more costly development of unconventional resources; hence the need to limit its dividend payouts.

Oil Climbs to a Three-Month High on Europe Debt Optimism (Bloomberg)

Oil futures rose to a three-month high in New York today on yet another round of optimism that European leaders will make progress in resolving the region's debt crisis this week. West Texas Intermediate crude for September delivery touched US$97.60 a barrel in midday trading, the highest level since May 10. European benchmark Brent oil added 1% to reach US$114.88 a barrel.

Gas Soars, But Don't Omit Oil and Coal (Financial Times)

The quarter that ended with June marked the first time that natural gas and coal contributed equally to power generation in the United States. In a sign of gas' rising profile, Houston's Cheniere Energy Partners recently announced that it received a $1.5-billion check from a consortium of partners to build two natural-gas liquefaction terminals in Louisiana. But as this article reminds us, energy investing is a volatile world, so it's best not to put all your eggs in the natural-gas basket.

How Rising Well Costs Are Reshaping the Oil Patch (The Globe and Mail)

Drilling a well in western Canada today costs three times as much to drill and complete as it did six years ago. That rapid and significant cost increase is causing major ripples in the character of the Canadian oil and gas industry, including greater vulnerability to weak commodity prices, the need for more upfront capital, and increased reliance on deep-pocketed investors.