Oil: 'To the Moon'?

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". . . we believe that the world's spare oil capacity will be gone by 2011."

The market is underweighting a potential oil supply crunch that could reignite higher prices. On the supply side, the current economic slowdown has eased significant exploration ventures. This may cause a bottleneck, as future demand, spurred by emerging market growth, outpaces supply. Looking at the converging paths of new supply coming online and future oil field decline rates, we believe that the world's spare oil capacity will be gone by 2011.

Giant oil fields, accounting for most of the world's oil production, have seen production rate declines. Concurrently, the rate of decline for smaller fields could be greater than, if not equal to, their giant brothers. New production has only served to sustain recent global production levels, and the carrot of optimism being waved in the form of alternative energy will not alleviate the burden oil carries as the world's main source of energy.

A shift is occurring between national and international oil companies. Oil production at nationals will account for most of the increases in future production. As production becomes concentrated in a small number of countries and emerging markets begin to account for greater consumption of future production, inefficiencies and supply disruptions will likely lead to volatile spikes in pricing.

M&A activity will be driven by large-cap energy names that are thirsty for additional reserves. Traditional growth will be spurred from historically non-traditional exploration sources. Large firms will look to snap up smaller cash- and credit-strapped companies. Consequently, we believe that investors will benefit from the industry's rapid pace of M&A activity.

The effects of massive stimulus packages by the U.S. and industrialized nations will likely pressure oil prices higher on two fronts—a weakening U.S. dollar and higher consumption. Given the accelerating economic decline of many OPEC countries, we believe they will be hard-pressed to increase capacity until oil reaches ~$70 per barrel. If OPEC does not reverse production cuts, growth in future supplies may fall behind a stimulus-driven recovery of demand, leading to higher oil prices.

We believe that future supply concerns have the potential to be a Trojan horse, besieging the world again with higher oil prices. It is only a matter of when, not if, oil prices move higher.

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