A look at why we might not yet have seen the top of the oil price rise.
"We believe oil will continue trading within a large range between US$24 and US$38… Longer term however, we see this as being a consolidation phase within a larger bull market with ultimately higher prices to follow."
"While reluctant to use the phrase, ‘this time its different’, we believe the reality is that cheap oil is a thing of the past."
The above quote came from one of our companies earliest reports, published on 16 January 2001. The simple equation of supply and demand was the basis for our bullish view and remains so today. Demand is increasing every year, while supply is constrained by a lack of past investment, as well as the absence of any sizable new discoveries.
Five years on from our bullish prognosis, energy prices remain at the forefront of financial headlines. While oil has displayed significant volatility during the ascent to all-time highs above US$70 a barrel, we remain resolutely bullish about the direction of prices over the longer term.
The case for a high oil price is as compelling as ever. Global demand remains robust with worldwide needs currently around 85 million barrels a day. By 2030, the International Energy Agency predicts this figure will more than double, driven by growth in China.
Supply meanwhile continues to be tight, with production expected to be around 84 million barrels a day this year. Looking ahead we believe it will be difficult to increase output meaningfully. A prolonged period of low prices during the 1980s and 90s caused an under investment in production and refining capacity.
The ability of the major oil producing countries in the Middle East to ‘turn on the taps’ is also in question. In addition to speculation that Saudi Arabian fields are now in decline, doubts linger over reserve estimates, with no independent verification in more than 20 years. If Saudi output falls short of meeting global demand, new oil fields in the development stage in Russia and elsewhere, may struggle to deliver enough production to plug the gap.
Supply disruption in the form of geopolitical tension remains a real threat to oil price stability. The ongoing dispute over uranium enrichment between the US and Iran could ultimately lead to another war in the region. In such an event the world’s fourth largest oil producer would likely cut off supplies which we believe would send prices soaring towards US$100 a barrel.
So given our prognosis for the oil price, what does this mean for the sector? In our opinion the price of many oil companies is too low. Essentially, this is because many analysts remain conservative in their oil price forecasts. Over the past two years estimates of average prices (and earnings) in the sector have constantly proved to be ‘behind the curve’, with upward revisions a common occurrence.
We expect analyst valuations will need to play catch up at some point once the reality sinks in that high oil prices are here to stay. A swift re-rating of earnings expectations would provide a sharp boost for the share prices of quality oil companies in our opinion.
The oil producers are naturally in an excellent position to take advantage of ongoing strength in energy prices. Companies such as BP, Shell, and Statoil have already proven this with each delivering record earnings and cash flows.
"We expect analyst valuations will need to play catch up at some point once the reality sinks in that high oil prices are here to stay."
Pure explorers meanwhile offer greater return potential but risk is also higher. Investors should be aware that the valuation of many of these companies is heavily weighted towards the expectation of future drilling results. At Fat Prophets we prefer to focus on companies (e.g. Dragon, Dana, JKX, Burren) which have exploration upside but also robust production to underpin earnings growth.
In recent weeks the oil price has pulled back by as much as 10 percent after peaking at a record US$75 per barrel in April. While further consolidation is likely in the near term, support between US$69 and US$67 underpins the price in our opinion.
We believe the various oil price corrections that have occurred over the past two years are symptomatic of the behaviour which occurs in a primary bull market. In such times the bulk of participants, previously conditioned by a bear market, generally consider a period of advancing prices to be unsustainable. They head for the exit, only to return after contemplating the unrelenting fundamental market drivers in place.
Over the longer term, and as part of a diversified portfolio, we recommend Members maintain exposure to the energy sector. On the flip side we remain wary of large exposures to industries which use significant amounts of oil in the production process. Margins will suffer if companies are unable to pass on the ever increasing high costs of fuel.
And let’s not forget the US dollar, which also helps explains why the price of oil has been rising. The world is awash in US currency. Too many US dollars seem to be chasing too few commodities these days. We believe the rise in the price of oil over the past few years is partly due to the US dollar losing purchasing power.
While reluctant to use the phrase, ‘this time its different’, we believe the reality is that cheap oil is a thing of the past. The world has located most of the large scale, near surface deposits, and many major oil fields are entering long term production decline.
There is still plenty of oil left in the earth’s crust. The problem is the most accessible deposits are depleting and the cost of extraction is increasing. The Canadian oil sands deposits in
A break above US$74 will indicate renewed upward momentum and a likely re-test of the April all-time high. We maintain our view that levels beyond US$100 per barrel are achievable in the years ahead.
The Fat Prophets Portfolio contains a diversified exposure to the energy sector. For Members without exposure, we intend to continue recommending quality oil stocks during periods of consolidation and correction.