Playing Oil

Back in March of 2009, oil prices were at a depressed level, particularly given the marginal cost of incremental supply that we need to satisfy demand. Since then, oil moved up almost 70% and closed the month of April at around $86 per barrel.2 This is a significant improvement for companies operating in this industry. It should be noted, however, as of this publication date there has been a pullback in oil prices as worrisome economic developments in Europe set back markets around the globe.

Deep water exploration, for example, requires oil to be above $60 a barrel to generate economic returns, so anything below that is not a reasonable level to be maintained longer term, especially once demand returns and more exploration and development is required. However, oil at $80-$85 a barrel reflects, we believe, a continued recovery in demand globally for oil. Currently, we do have excess supply in the market that could put temporary pressure on prices.

Our strategy is not to guess a specific price level for oil. Instead, we try to come up with a range-a high and a low-and if oil is trading in that range, and the related stocks appear to reflect that level or less, we feel comfortable about investing in the equities. We believe that this year thus far, oil has been trading within a healthy range, though we are monitoring market. developments just mentioned. Regardless, we try to focus on companies that can thrive in the current, or an even stronger, price environment.

Our profile of the ideal oil company is one that has a core base of production, say about 60-70% of assets, with the rest in assets offering exploration or development upside potential. That way, the company has some stability from consistent production and the possibility of benefiting if it finds more oil reserves.

One example of the types of oil companies we look for is a large, California-based petroleum company. About 60-70% of this company's reserves and production come from onshore fields in the U.S., primarily in California and Texas. These fields have been producing a long time, are relatively stable and have consistently grown by a couple of percentage points every year.

The company also has reserves in the Middle East and Latin America, which gives it development upside potential in those markets. In addition, only about half of its cash flow has been needed to keep production growing in its core assets. This allows more cash to be reinvested in growth opportunities.

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¹ CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

² Bloomberg LP, as of April 30, 2010