The best way to profit from the oil shock

Oil shocks are bad news - they are almost invariably followed by a global recession. And a further rise in the price of oil will deal the West's fragile economies another serious blow. But things are not completely hopeless, says John Stepek. There is a bright side for investors.

By John Stepek

published 3 March 2011

in Features

The turmoil in the Middle East is turning out to be oddly like the eurozone crisis.

Markets don't quite know what to do with themselves. A day goes by without any major developments, some decent economic news comes out of the US, and so stocks drift higher. But then news of protests breaks out elsewhere, the oil price jumps, and everyone panics again.

They're right to be worried. Oil shocks are extremely damaging to the global economy. But believe it or not, there is a bright side to this.

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The soaring oil price and fear over instability can only accelerate our hunt for alternative sources of energy and oil. And there are plenty of ways for investors to profit from this.

Oil shocks are bad news

Anatole Kaletsky noted in The Times the other day that there have been five oil shocks since 1973, and all five were followed by global recessions. Defining exactly what level constitutes an oil 'shock' isn't easy. Various analysts will offer various rules of thumb, and I think you could still debate whether or not the current surge is a definite recession inducer.

But it probably is fair to say that if we stay at these levels for very much longer, or prices go much higher from here, we're looking at a grim situation, particularly for fragile developed world economies. So what can we do?

Kaletsky's solution to the problem was to suggest that we twist the arms of Saudi Arabia's leaders up their backs. If they don't flood the market with oil, we should make sure that they know there will be no safe haven for them in the West if they get kicked out by their own people.

This tactic strikes me as a tad impractical, not to mention a little impetuous. Autocrats tend to be quite stubborn in the face of threats. That's generally how they get to stay autocrats. And while there's a danger of an uprising in Saudi, it's certainly no sure thing. In short, I don't think we've got the leverage to be threatening the leaders of the world's biggest oil producer with anything.

Moreover, if the Saudis aren't unleashing quite as much oil as we'd perhaps like, there could be a more worrying reason for it. Fatih Birol of the International Energy Agency has described Saudi as the "central banker" of the oil world. The trouble is, unlike a central bank, the Saudis can't just press a button and magic oil out of nowhere.

Rumours have swirled about Saudi reserves for decades. A belief that they along with the rest of oil cartel Opec don't have as much oil as they claim to have, is a key factor in the 'Peak Oil' argument. So maybe pumping more just isn't an easy option.

Breaking our dependency on Middle East oil

Whatever the problem, there are two issues for the rest of us here. One is our continued dependence on oil itself. There doesn't seem to be a lot we can do to address that rapidly. Transport is the main thing we use oil for, and the day we're all driving electric vehicles, scooting cross-country on high-speed trains and going on holiday in Zeppelins, is a long way off.

But the second issue is perhaps more readily addressable. This is the problem of where our oil comes from. It's never been very comfortable to be so dependent on the Middle East. It's always been a volatile region. And as the West is now acutely aware, we've had to compromise our lofty principles quite severely in the name of energy security doing deals with regimes we're now lobbying to have thrown out of power.

Could 'unconventional' reserves be the answer?

So here's an interesting fact that may have escaped your attention. US oil output in 2010 rose to its highest level since 2002. In fact, reports the FT, analysts believe that the US was "the largest contributor to the increase in global oil supplies last year over 2009 and is on track to increase domestic production by 25% by the second half of the decade".

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Of course, this isn't a solution. America would still depend on imported oil, "which accounted for roughly half of US demand in 2010". But producing more domestically would certainly reduce the vulnerability to supply shocks.

So where did all this extra oil come from? The answer is 'unconventional' reserves. We've been writing about the natural gas 'revolution' for a while now. To read more detail on this, have a look at this piece which my colleague David Stevenson wrote up for MoneyWeek magazine last year: Profit from natural gas the fuel of the future. In short, breakthrough technology has made it far easier and cheaper to get natural gas out of 'gas shale'.

Less widely reported is the fact that the same technology has made it possible to get oil out of 'oil shale' as well. Various techniques, such as 'fracking' which involves using high pressure water to crack the rocks and release the oil, have slashed the cost of production. Of course, it's still a lot more costly than producing oil in Saudi Arabia. But you don't have the political risk, and with the oil price at its current level, you can spend a fair bit on production before it becomes uneconomical.

It's not a complete solution to our dependence on the Middle East by any means. But these sorts of problems are solved incrementally, not by magic bullets. I remember one of the first times I wrote on this topic for MoneyWeek, about five years ago, oil shale was right on the fringes of 'alternative' oil. It was simply far too expensive. Pundits said it could be decades before it was viable. Well, now we're using it.

We cover this topic and the companies that are profiting from it in more detail in the next issue of MoneyWeek, out tomorrow. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.