Crude oil and the petroleum products refined from it are what fuel the global economic engine. There are no readily available and viable alternatives for the various fuels that are refined from crude oil and necessary for internal combustion engines to run and goods to be transported. As a result, the global economy is held hostage to the supply of oil.
Because there are no substitutes for oil, the demand for these fuels is inelastic. In simple terms, that means oil and its byproducts will be consumed by the global economy, regardless of the price demanded by the oil companies and irrespective of the economic and financial damage caused to the other segments of the world's economies.
As a result, the oil industry can and does operate primarily on a cost-plus pricing basis. That means that all of the various actors needed to access crude through to the end consumer -- extraction, transportation, refinement and delivery of end product -- have little need to invest in systems and technologies that reduce the costs incurred by any one of them. All costs are ultimately borne by the consumer.
This also means that all financial investments made to advance technology in the space are dedicated to enhancing the prospects for extraction, regardless of cost. There is actually a disincentive to invest financial resources in reducing costs, because it is a misallocation and inefficient use of capital that can be used more profitably in extracting more oil.
This concept, however, as simple and conforming to fundamental economics, finance and business practices as it is, is not only politically incorrect, it must not be discussed or acknowledged, lest agitating political operatives attempt to pursue financial regulation targeted at the industry.
As a result, and as a means of distraction, the industry pre-emptively diverts attention away from such logic by promising that technology being pursued to increase extraction will eventually result in lower costs throughout the production process and ultimately to the end consumer.
This is not to say that all companies involved in the process of oil extraction, transportation, refinement and end delivery have the same risk profile. Smaller companies and those involved in the more expensive extraction methods are clearly more at risk to a decline in prices caused by recessions or temporary gluts in the supply chain than larger and more diverse companies.
From an investor's position, rather than a speculator's position, the oil industry and its largest companies offer the potential for something as close to a secular financial arbitrage opportunity as is possible for retail investors to access through the liquid, publicly traded capital markets.
That's not to say there aren't other risks. Political and regulatory risk could limit profits, global recessionary risk could temporarily affect revenue, earnings and stock price, and company-specific risk was highlighted most recently by the BP Deepwater Horizon oil spill, although even that was a temporary financial event for BP. There is no industry risk, however, as there is no substitute for oil and none in the foreseeable future. It is the top of the food chain, with no predator, and as such, there is no risk that it may become financially unviable, no matter how expensive extraction costs are or how expensive the end products become to consumers.
For the purposes of this column, I've separated the industry into three categories for investors to consider: oil extractors, industry service providers and large integrated suppliers.
Among oil industry service providers, the best is National Oilwell Varco (NOV).
The extractors are a growth play, while the service providers and integrated suppliers are growth and income.
More importantly, however, they all serve as a portfolio hedge against the negative consequences of high oil prices, to which the rest of the economy and publicly traded companies are at risk.