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From Special Report:

Is there still value in oil?

With industrialising nations driving demand, some strategists believe the outlook for oil is still constructive

By Nyree Stewart | Published Apr 30, 2012 | comments

Concerns about geopolitical tensions in the Middle East, particularly in relation to Iran, have helped push Brent crude oil futures higher, reaching a peak in March 2012 of more than $126 a barrel.

While this is significantly lower in dollar terms than the figure of almost $150/bl in the oil bubble of 2008 – when the Brent crude oil price rose sharply to a peak in July before dropping to a low of $38.44 by the end of December – there is a growing consensus that $100/bl is the new equilibrium.

Angelos Damaskos, chief executive of Sector Investment Managers and manager of the £52.2m CF Junior Oils trust, points out that in spite of the eurozone crisis and potential slowdown in the developed world, developing countries such as China, India and other industrialising nations are still driving demand for oil.

“After the crisis of 2008 demand in western Europe, the US and elsewhere dropped significantly but it has now reached a level where the standard of living does not justify much further cuts. Even though private consumers might drive less because petrol prices are rising, we still need oil to power tankers, commercial ships, aircraft, trains and industrial capacity, which means demand becomes quite inelastic to the price of oil.

“It is unlikely demand will soften further in the developed world, whereas the developing world still demands more and more oil. So the demand outlook is constructive and supportive for oil prices, especially given the relative shortage of supply.”

On the supply side, Frances Hudson, investment director and global thematic strategist for Standard Life Investments’ (SLI) multi-asset investing team, points out instability in the Middle East and North Africa (Mena) region is one of the key concerns.

“Of the Opec [Organisation of the Petroleum Exporting Countries] producers, Saudi Arabia is the country with meaningful spare capacity. It is the low cost producer and can vary supply in response to price. Other major producers such as Venezuela and Brazil in Latin America, Russia, China, Nigeria, Algeria, Libya and Iraq all have lots of political considerations.

“After the global financial crisis and economic recession, and the Arab Spring in 2011, the supply dynamics have changed. The prices needed for producers to break even or make a profit increased.”

Mr Damaskos agrees, adding: “Mena is the world’s most prolific producer of oil, so if we have these upsetting factors in that part of the world it can cause short-term supply plunges. For example, if Iran were to start any military action, it could cause a blockage in the Straits of Hormuz that would cause a problem in the transportation of roughly 16 per cent of the daily [oil] consumption of the world and that could spike up prices to crazy levels, perhaps above $200/bl.

“It is unlikely this will be a sustained long-term situation. Nevertheless, stability in the Middle East causes the parties in power such as the monarchy in Saudi Arabia to think about ways to keep the population happy.

“Saudi has openly stated they are spending many billions of dollars every year in social programmes to keep their people happy and in order to finance those social programmes they need the oil price to stay above $100/bl. So there are many reasons why this most prolific oil producing region of the world is unlikely to open its taps and supply the world with more oil, even if they had the spare capacity, and bring the prices down.”

The International Energy Agency (IEA) notes in its March oil market report: “It is supply side issues that are currently dominating market sentiment. Geopolitical issues in South Sudan, Syria and Yemen combined with weather related and technical problems in the North Sea and Canada have knocked roughly 750,000 barrels per day out of the market so far in 2012. In addition, OECD crude oil inventories are still hovering at the bottom of the five-year average in spite of the highest levels of Opec production in more than three years.”

Mr Damaskos suggests the market is likely to see rising oil prices for years to come, albeit with some short-term volatility if there is more stability with regard to Syria and the Iranian situation.

But he warns: “Medium to long term we think prices will again rise beyond the $150/bl we saw in July 2008. It is highly unlikely it will drop below $100. Saudi Arabia said openly they want to see oil prices above $100 so if the price drops we believe they will urge Opec to cut production.”

Sustained price

Research by McKinsey & Company in November 2011 also highlighted the possibility of a sustained oil price spike on the basis that when global economic performance becomes more robust, demand is likely to grow faster than supply.

In its paper “Another oil shock?” the organisation suggests there is a possibility the current decade will see oil prices bouncing between $125/bl and $175/bl, and warned if oil prices spiked and remained at $150/bl for a number of years global growth would fall by up to 0.9 percentage points in the first year, with the global economy ending up $1.7trn (£1.05trn) smaller by 2020.

The consultancy adds that while there are still approximately 1trn barrels of conventional oil estimated to still reside beneath the earth’s surface, plus the oil that can be extracted from less conventional sources such as oil sands, the problem is how much spare oil production capacity exists.

Mr Damaskos notes: “The easy oil has been found and the large oil fields that are easy to access and extract oil from have been in decline for many years. We are now looking to increasingly more complex projects and much more expensive projects to bring new oil reserves to production.”

He explains countries outside Mena do not appear to have any spare capacity, with oil production rates in Russia believed to have been falling in recent years through lack of investment, while the recent oil discovery by Brazil in the Campos Basin is expected to take eight to 10 years before it is brought to production because of the difficulty of reaching and extracting the oil.

“Many analysts believe the cost of production from these fields because they are so difficult to reach and so complex to build the necessary infrastructure, they might cost in excess of $80-90/bl so at that marginal cost they will definitely need oil prices to be at $110/bl or more in order to justify an economic rate of return,” says the manager.

With demand expected to continue to rise and supply becoming more challenging it appears that higher oil prices are here to stay.

However, some natural resources managers are slightly more cautious. Bradley George, co-manager of the £326.5m Investec Enhanced Natural Resources fund, points that oil prices have weakened slightly in March – Brent crude closed at $118/bl on April 19 – over rumours the IEA might release stocks from its Strategic Petroleum Reserve (SPR), supported by the French, British and US governments.

“Over the past few months the global oil market has suffered a number of smaller supply disruptions which have offset the return of production from Libya to the market. The recent higher levels of the crude price have increased our estimate for 2012 from $100/bl to $105/bl,” he says.

“[However] we expect further moderation in prices in the near term as political issues wane and demand reacts to high prices. We maintain a $100/bl assumption for the long term, with our high price estimates reflecting the tightening supply/demand fundamentals plus higher marginal costs of supply.”

Nyree Stewart is deputy features editor at Investment Adviser

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