The Number One Lesson for Oil Investors

Of course, no one knows what the price of oil will be, but there is no shortage of forecasts. Goldman Sachs says it will be $95 by the end of 2010. Deutsche Bank says $65. They are all guessing.

There is one thing we do know. And fortunately, this is the most important thing to remember as an investor in oil: The market is still pricing proved oil reserves at less than replacement cost. In other words, it is cheaper in today’s market to buy proven reserves in the stock market than to drill for new ones…

Here is a scatter plot by an energy firm I respect a great deal, Lucas Capital Management. It shows you the universe of stocks it follows. EV is enterprise value, which you can think of as the cost to acquire the entire business, both the stock and the debt. So EV/BOE shows you how much you are paying per barrel of oil. It plots this number against reserve life. Take a look:

Cheap Oil Reserves

The math is easy. You have lots of companies here in which you can buy oil in the ground for under $10 a barrel… and it costs on average $25 a barrel to replace it.

I could not make a more compelling argument for oil stocks than this.

Whether I’m buying potash mines or gold mines or factories or oil rigs, if I can buy it in the stock market for less than it costs to replace those assets — and as long as I’m not buying buggy whips — then I’ve got a good chance of making money.