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The Bullish Case for Oil and How to Play It

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Some analysts see crude heading to $95 this year.

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So say commodities analysts at Morgan Stanley (MS). In a recent research report, the number-crunchers there told clients that the Street is way too conservative with its outlook: Expect oil prices to move significantly higher this year, they argue.

Morgan Stanley's team, led by Hussein Allidina, introduced a 2010 year-end price target of $95 and a 2011 estimate of $100. Their 2012 forecast of $105 is 15% ahead of the Street.

This morning, oil is trading around $74.

The bullish crude outlook comes from the analysts' strong outlook for economic growth -- they see GDP expanding at a healthy 4% in 2010 mainly driven by the energy-intensive emerging markets.

Allidina and his team also estimate that inventories will increase slightly over the next few months. However, in the second half of the year, we'll see either sharp inventory declines or the need for an increase in OPEC production.

Either will be enough, they write, to turn the market's attention to the long-term supply constraints underpinning the structural case for oil, ultimately lifting the market toward their target price.

Moreover, the analysts note that higher prices have done little to dent demand growth in the countries that matter.

In China, since 2005, gasoline demand is up 41% despite prices having risen by 122%. In India, from 2005 to 2008, prices rose by 20% and demand rose by 29%. So prices will need to go substantially higher to ration demand.

Morgan Stanley analysts also argue that rising inflation expectations will be an increasingly powerful driver of oil prices and they say they'll be monitoring the TIPS market as a key macro guide to where oil prices are heading.

Jon Markman of Markman Capital Insight points out that inflation expectations, as represented by the price of inflation-protected Treasury bonds or TIPS, continue to climb.

Since December 28, he says, the iShares TIPS Bond Fund (TIP) has climbed 1.6% while the S&P 500 has lost 3.1%. The TIP fund easily exceeded its 2008 highs and remains in a well-established uptrend, he emphasizes.

How to play this as an investor?

Morgan Stanley offers a few ways to play the rising oil tide, including: Suncor (SU), Statoil (STO), Hess (HES), InterOil (IOC), Woodside, CNOOC (CEO), Tenaris (TS), Baker Hughes (BHI), and BP (BP).

Markman, on the other hand, urged his clients to consider playing this thesis with the ProShares Double Crude Oil ETF (UCO), if it trades above $11.40 with a target of $13.25.

For another opinion, we also checked in this morning with Stephen Schork, editor of The Schork Report.

Fact is, the analyst and trader says, contrary to whatever the eggheads of Morgan Stanley tell us, the fundamentals don't support $100 oil.

The demand isn't there, he says, arguing that oil should be below $60.

"Chevron (CVX) in the fourth quarter lost $600,000 a day on their refining operations," he notes. "The second-largest oil company in the largest oil consuming country in the world couldn't make money on $70 oil, refining it. So show me the demand."

However, Schork is quick to point out that doesn't mean we won't hit $100, as Morgan Stanley forecasts.

"Morgan Stanley, Goldman Sachs (GS), and JPMorgan (JPM) call the shots, regardless of the fundamentals," he says. "This is a speculative-driven market and speculators will be encouraged by this kind of pie-in-the-sky forecast. There is a lot of hot money chasing commodity prices higher."

Schork concludes, "So can we go to $100? Sure. Does it belong there? Absolutely not."

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No positions in stocks mentioned.
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