It's time to invest for $100 oil

By Michael Brush

Investors, get ready for $100-a-barrel oil.

Energy experts say this kind of portfolio-wrenching spike in the price of oil isn't far off. They chalk it up to two factors:

• There are basic underlying energy shortages, while global demand from economic hot spots like China and India ratchets higher every month.

• A half-dozen potential geopolitical flash points around the globe could flare up at any moment, increasing worries among oil buyers at best and disrupting supply at worst.

"We think $100-a-barrel oil is very possible," says Frank Holmes, who manages the U.S. Global Investors' Global Resources Fund (PSPFX), one of the top-performing energy funds, up nearly 50% in the past year.

Strictly speaking, that kind of spike would be nothing new. Adjusted for inflation, oil traded at equivalent levels early in the 1980s. But a lasting move above $100 a barrel would have devastating effects on your investment portfolio if you were ill-prepared.

You would miss out on gains if you aren't long energy producers with long-lived reserves in politically safe regions like North America -- think Encana (ECA, news, msgs), Canadian Natural Resources (CNQ, news, msgs) and Suncor Energy (SU, news, msgs). Also getting a boost would be alternative-energy plays such as Pacific Ethanol (PEIX, news, msgs) and Green Plains Renewable Energy (GPRE, news, msgs), and ethanol and uranium supplier Cameco (CCJ, news, msgs).

The bad news is that a move to $100 for oil would send gasoline above $4 a gallon, taking another bite out of consumer spending. This would hurt retailers serving lower-income consumers, such as Wal-Mart Stores (WMT, news, msgs), Dollar Tree Stores (DLTR, news, msgs) and 99 Cents Only Stores (NDN, news, msgs), and restaurant chains such as Wendy's International (WEN, news, msgs), Brinker International (EAT, news, msgs) and CBRL Group (CBRL, news, msgs).

Here's a closer look at what could push oil over $100 -- and at the potential winners and losers.

Supply-demand constraints

Holmes thinks supply constraints alone will be enough to put oil above $100, without any help from geopolitical flare-ups. In a world with 6.5 billion people, Holmes said, "3.5 billion are in economies that must grow at 6% a year or politicians lose their jobs."

By this he means that a sharp economic slowdown in rapid-growth countries such as China or India could lead to regime-toppling social unrest. So political leaders know they have to keep their economies humming, and that requires more oil. "They are embracing the American dream," says Holmes.

They have a ways to go, but a few quick numbers show why oil consumption should increase dramatically along the way. Per capita oil consumption in China and India stands at 1.7 barrels a year. In Mexico, the number is seven barrels; it's 17 in Japan and 28 in the United States.

China's demand for oil grew by 11% in the most recent quarter, and demand in India was up 5%, according to UBS Securities analyst Jan Stuart. He thinks global demand for oil will grow by 2% a year through 2008.

But at the same time, there are supply constraints. A dearth of investment by oil companies during the 1990s when oil was cheap resulted in limits on reserves and production now. Spare capacity among Organization of the Petroleum Exporting Countries (OPEC) members is tight, while non-OPEC growth is flat except for new production from former Soviet Union countries, says Goldman Sachs oil sector analyst Arjun Murti.

The risks are global -- and huge

Besides basic supply-demand constraints, several geopolitical hot spots could flare up and make oil prices spike:

• Iran: Iran says it wants to produce more electricity from nuclear power so it can sell more oil abroad. But U.S. intelligence experts suspect the country is also developing nuclear weapons that could fall into the hands of terrorists. "The U.S. is pretty determined to stare 'em down," says Tom Petrie of Petrie Parkman & Co., the Denver brokerage and investment bank that specializes in the energy sector. If the confrontation boils over into military strikes on Iranian nuclear facilities, the price of oil would go bonkers. Iran could retaliate by cutting back production or closing the Strait of Hormuz, through which much of the oil from the region passes, speculates Rep. Roscoe Bartlett, R-Md., who follows energy issues closely.

• Iraq: Ongoing attacks by insurgents on the energy infrastructure make it impossible for Iraq to reach its goal of producing 3 million barrels of oil a day. Recent levels are closer to 2.5 million per day.

• Saudi Arabia: Saudi Arabia is the largest OPEC producer and controls much of the cartel's spare capacity. But it faces threats from al-Qaida and potential terror strikes on its oil infrastructure. The country's regime also faces civil unrest. "One scary scenario is that zealots take over in Saudi Arabia because they are unhappy with the royal family," says Bartlett.

• Nigeria: Nigeria's rich reserves make it one of the world's top oil-producing nations. But most of Nigeria's oilfields are in the Niger Delta, a region where poverty and unemployment fuel a long-running conflict between locals and the oil companies. Attacks by rebels on the energy infrastructure have shut down about a quarter of the country's production this year.

• Venezuela: Venezuela, the world's fifth-largest oil exporter, is in talks to become a major supplier to China. That would tighten supplies around the globe, since more oil would be locked up in transport during the trip to China, says Petrie. Another potential problem is Venezuela's increasing ties with countries such as Russia, which is supplying military equipment, says Holmes. If this rekindles the Monroe Doctrine and the United States takes steps to limit Russian involvement in Venezuela, that would be bad news for oil prices.

• Hurricane season: Last year's hurricanes along the Gulf Coast destroyed energy infrastructure, causing a temporary spike in the price of oil and gas. Hurricane season just began, and the same thing could happen this year.

Profiting from $100 oil

Goldman Sachs analyst Murti says that the recent pullback in energy company shares means the current high price of oil is priced into the stocks. But he thinks oil can go even higher, so he is telling clients to buy stocks like ExxonMobil (XOM, news, msgs), ConocoPhillips (COP, news, msgs), Canadian Natural Resources, Suncor, XTO Energy (XTO, news, msgs), Southwestern Energy (SWN, news, msgs) and Bill Barrett (BBG, news, msgs).

Here are some other approaches:

The safety plays: In case of heightened geopolitical strife in the Middle East, oil companies with holdings in "safe" regions like North America would "go through the roof," says U.S. Global Investors' Holmes. These include Suncor, EnCana and Canadian Natural Resources.

Likewise, investors would view these three as "safe" in a lasting $100-a-barrel oil scenario since they have long-lived reserves locked up in the form of Canadian oil sands, says Morningstar analyst Elizabeth Collins, though she thinks these stocks still look too pricey to buy here.

A related Canadian oil-sands play is Compton Petroleum (CMZ, news, msgs). It produces natural gas near the oil-sands companies, which will use a lot of natural gas in production. And since Compton Petroleum's energy fields are in Canada, it could benefit if hurricanes shut down production again along the Gulf Coast and push up natural gas prices, says Morningstar's research director, Patrick Dorsey.

Unhedged energy companies: Energy companies that haven't used financial instruments to hedge against changes in oil prices will benefit if oil spikes, says Amir Arif, an analyst with Friedman, Billings, Ramsey & Co. This includes Suncor, and any of the integrated majors, such as ExxonMobil.

Alternative energy plays: A spike in oil prices would give a boost to alternative energy plays like Pacific Ethanol and Green Plains Renewable Energy in ethanol, and uranium plays like Cameco.

Natural gas plays: These would benefit as well, because energy users would switch to natural gas, says Morningstar's Eric Chenoweth. The key is to go with companies that already have a lot of reserves locked up for production, so they don't have to buy pricier reserves after oil tops $100. Companies in this category include: Cimarex Energy (XEC, news, msgs), Apache (APA, news, msgs), Anadarko Petroleum (APC, news, msgs) and Devon Energy (DVN, news, msgs), plus Goodrich Petroleum (GDP, news, msgs) and Chesapeake Energy (CHK, news, msgs), which continue to see a lot of insider buying.

The losers

At $100 a barrel for oil, gasoline would go above $4 and hurt retailers serving lower-income consumers, like Wal-Mart Stores and the fast-food chain Wendy's. Airlines also would suffer from higher fuel costs.

But there's a chance that gasoline prices of $4 to $5 could cause a significant consumer slowdown that might lead to a recession, says Ed Yardeni, the chief investment strategist at Oak Associates. "The psychological impact of $4 or $5 at the gas pump would probably push consumers over the edge. It would be pretty ugly across the board," he says.

The good news is the Federal Reserve would lower interest rates, Yardeni believes, because a superspike in oil would increase the chance of a recession more than it would spark higher inflation.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for The New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.