Higher oil prices are coming. The case for global growth and political turmoil is too compelling. By James K. Glassman, Contributing Columnist August 31, 2007 It probably comes as no surprise that the price of a share of stock in an oil company is closely tied to the price of a barrel of oil itself. For example, at the end of 1998, Occidental Petroleum (symbol OXY) traded at $6.47 a share, adjusted for splits. At the beginning of July, Oxy was at $59 -- roughly a ninefold increase. Over the same period, the global average price of crude oil, according to the Energy Information Administration, rose from $9.48 to $68, which means roughly a sevenfold increase.Upside advantage Occidental makes most of its money in oil exploration and production, or E&P. In energy jargon, it is mainly an upstream business. A company such as ExxonMobil, by contrast, has substantial upstream and downstream operations. As an integrated firm, Exxon extracts oil, distributes it through tankers and pipelines, refines it, and sells it to businesses and the public. As a result, Exxon, BP, Shell and other integrated companies benefit less than E&P firms when oil prices soar. The upstream side of the business does well, but downstream, high oil prices raise costs for wholesalers and dampen demand by consumers. Ultimately, stock prices reflect this. Since 1998, Exxon shares have little more than doubled. BP stock has gone from $45 to $74. Of course, if you own shares in an integrated oil company, you get a relatively smooth ride. According to Value Line Investment Survey, Exxon, BP, Chevron and most other integrated firms are less volatile than the market as a whole. Such stocks also pay nice dividends. Since 1991, Chevron's dividend has gone from 81 cents to $2.32 a share, rising every year. So if you're looking for stability, buy big integrated oil. But if you believe energy prices will stay high, then the place to be is exploration and production. Advertisement As E&P stocks go, Oxy is pretty tame. Parallel Petroleum (PLLL) has risen 15-fold since the depths of the late 1990s. Chesapeake Energy (CHK) has soared from less than a dollar at the end of 1998 to more than $35 in mid 2007. But investors care about the future, not the past. E&P shares have risen with the prices of oil and natural gas (I'll get to that later), as well as with increased efficiency and greater unit sales. But will prices remain at their current levels, or perhaps even increase? Yes, says Wayne Andrews, a managing director at Raymond James & Associates, who has a sparkling record as an analyst. In a report issued in early July, he and his colleagues say they are "thoroughly bullish on both oil and gas long term." Andrews forecasts $70 a barrel for oil at the end of 2008. He ranks Occidental, which gets 78% of its revenues from producing crude oil, a strong buy. Ditto Parallel and Bois d'Arc Energy (BDE), both much smaller companies with market caps of about $1 billion. He also gives a top rating to EV Energy Partners (EVEP), which trades as a limited partnership on Nasdaq. Andrews's reasoning is straightforward. First, OPEC, the 11-nation oil cartel that is responsible for about two-fifths of the world's oil production and two-thirds of its proven reserves, "has conviction to support a $60 oil price," which provides a reassuring floor for investors. OPEC alone can't determine prices; it was helpless in the face of past sharp declines, not only in the late 1990s but also during the recessions of 1991 and 2001. Still, OPEC members no longer believe that prices in the $60 range will slow global growth, and intentionally or not, their production has been falling. Non-OPEC oil production is also slowing considerably; Mexico's peaked in 2004, Russia's in 2003. Advertisement Worldwide boom Moreover, the global economy is booming. No nation of decent size is in economic distress at present. The business cycle has not been repealed, of course, but economic management -- especially monetary stewardship and tax policy -- has improved all over the world. "India and China," says Andrews, "are just entering the industrialization phase." Currently, the two countries consume two barrels of oil per capita each year -- less than 100 gallons. By contrast, South Korea and Japan consume about 15 barrels, and the U.S., 25 barrels. South Korea nearly quadrupled its per-person oil use between the mid 1980s and mid 1990s. If you assume that India and China will merely double their consumption, you still come up with a huge jump in demand. Finally, look at geopolitics. Effective sanctions or military action against Iran, the second-largest oil producer in OPEC, would almost certainly slash production and push global oil prices higher -- at least in the short term. A question of value These are cogent justifications, but how novel are they? Is knowledge of sluggish supply and rising demand already built into today's prices, for both oil and stocks? A top executive with one giant integrated company told me he thinks that oil today carries a geopolitical premium of $20 a barrel. In other words, the investors, speculators, businesses and consumers who set oil prices expect disruptions in Iran, Nigeria, Russia, Saudi Arabia, Venezuela or some other unstable energy-producing nation, and their fears are reflected in the price. So, one assumes, is the likelihood of another bad hurricane in the Gulf of Mexico. Andrews's price forecasts are on the high side. But many analysts foresee the same lofty ranges reached a few years ago. The more clever, contrarian investor may think that oil prices have peaked and will start dropping -- because of slowing global growth, a more-benign picture of geopolitical risk and rising supply gained through new technology. In that case, the right move would be to short E&P stocks or buy shares in companies, such as airlines, that benefit enormously from lower fuel costs (although airlines would also suffer in an economic downturn). Advertisement My own view is that higher oil prices are coming, mainly because the case for global growth and political turmoil is too compelling. But an even better bet than oil producers such as Oxy may be natural-gas producers such as Chesapeake and Cabot Oil & Gas (COG), both of which are rated "outperform" by Raymond James. Although that may seem a lukewarm endorsement, Andrews says it reflects worries that natural-gas prices will fall because this summer's heat has been fairly moderate, allowing reserves to build. "Gas likes cold winters and hot summers," he says, and buying shares in natural-gas producers is, in the short term, a wager on weather. Longer term, however, there is a lot to like about gas. For one thing, gas is nearly a closed system. We make our own in the U.S. and import very little (other than from Canada) because we have few liquefied natural-gas terminals and are unlikely to build many more. So, foreign supplies of natural gas don't enter into the equation. And today, Andrews points out, there is a disparity between oil and natural-gas prices. Normally the ratio of the price of a barrel of oil to that of 1,000 cubic feet of natural gas is six to one, or, at most, seven to one. That is the relationship based on the energy each source generates. Today, however, the ratio is ten to one. Because Andrews doesn't expect oil prices to drop, the route to reconciliation is a rise in gas prices. He is projecting natural gas delivered at the Henry Hub, in Louisiana, to be $7.08 at the end of 2007 and $10 at the end of 2008 -- a huge increase. What about alternative energy? That's a subject for another column. Just recognize that for the next few decades at least, oil, gas and coal will be by far the primary resources for global economic growth. Advertisement Smart additions Along with stocks such as Oxy and Chesapeake, a wise investor's portfolio should include at least one integrated oil company; an exchange-traded fund such as United States Oil Fund (USO), shares of which directly reflect the price of West Texas Intermediate light, sweet crude; and a mutual fund such as Fidelity Select Natural Gas (FSNGX), which has returned an annualized 17% over the past ten years. The final reason to own energy stocks is to hedge your bets. As gasoline and home-heating costs rise, you can at least have the small satisfaction that your E&P shares are probably rising, too. James K. Glassman is a senior fellow at the American Enterprise Institute and editor of its magazine, The American.