Oil

Two weeks on and oil has in fact broken all time highs, with prices reaching a record US$113 a barrel In our view three digit oil prices are here to stay.

The latest catalyst for the spike in prices was a US Department of Energy report showing that oil inventories dropped last week by 3.2 million barrels. Expectations were for an increase of around 2.2 million barrels.

We do not generally place too much store in such announcements in arriving at our long term expectations for the oil price per se. We regard weekly inventory announcements, speculation on OPEC production changes, etc as short term noise.

However we do believe that the sharp movements in the oil price on the back of any hint of supply disruption (such as the pipeline explosion in Iraq two weeks ago) or inventory number surprises underscores the tension in the long term oil market.

And this tightness is unlikely to go away. Certainly, the only relief in our view for the oil bears (in the short term) would be drastic action by OPEC. However the cartel looks unlikely to turn on the taps any time soon. No great surprise that the body is rather comfortable with US$100 oil.

As an aisde the US department of Energy estimates OPEC revenues this year at near to US$1 trillion. Curiously this is the same figure the International Monetary Fund estimates the financial sector will lose through the sub-prime debacle.

Net importers such as the US continue to be oil hungry (despite softening economies) and are unsurprisingly calling for a production increase by OPEC at any opportunity. Unfortunately for these users, there is probably just as much chance as a cut when the cartel meets next to discuss quotas.

On the face of it Opec ministers plead that there is plenty of crude around after a mild Northern Hemisphere winter, with global growth slowing, and inventories on the rise. To raise output now could therefore drive prices sharply lower. They blame high oil prices on the speculators.

Whilst there is some merit in this argument we believe a key motivation is the use of oil as a political weapon. Leading the calls for US$100+ oil is Venezuela, a country which hardly has the cosiest relationship with America. Also in this camp is Algeria whose energy minister (and Opec president) was quoted as saying: “there is really no need for increasing the supply ... stocks are in pretty good shape”.

Another point of reasoning is one of simple economics. Whilst oil producers are getting more dollars for their oil, these are becoming increasingly worth less. With the printing presses in America running, and the greenback continuing to depreciate it is natural that the recipients of ‘petrol dollars’ want more of them (so they can buy up US banks and other Western assets, mind that is another story).

And non-OPEC countries won’t be coming to the rescue with new supplies either. Production forecasts here are down on the back of lower output from Western Europe, North America and Mexico.

In any case even if OPEC were suddenly to do an about face, and were able to turn on the pumps (their ability to do so is limited in our view) this would merely create temporary weakness only. In our view the underlying long term trend in the oil price remains up regardless.

Global demand growth remains assured in our view depsite the prospect of weakness in America.

Recent comments by Mr Birol Fatih Birol, chief economist of the International Energy Agency (IEA) are worth observing. The burgeoning energy requirements of China, India, the Middle East and Russia, have accounted for 83 per cent of the world’s demand growth over the past two years. We expect this trend to continue with the emerging, rapidly industrialising countries of China and India leading the charge. The IEA is forecasting consumption of 87.5 million barrels a day this year, but this is set to double over the next few decades.

Reinforcing this belief is the degree to which oil demand has proven relatively price 'inelastic'; that is, consumer and industrial demand has not really eased off to any significant degree, despite record prices.

Meanwhile, the supply side will likely remain constrained by rising costs, sovereign risk issues, and a lack of infrastructure investment and world-class discoveries. The fact that oil producers are turning to technological challenging areas such as the Canadian oil sands, confirms in our view that all the easy ‘black gold’ is gone. And worldwide inflation is meaning that the costs of extracting reserves from such difficult places is also on the rise – the world can have this oil, but at a cost.

And supply/demand fundamentals aside, another key driver of the oil price (and indeed commodities generally) is likely to remain so – that is the waning US dollar.

Inflationary policies by the US Federal Reserve and other authorities should continue to provide a bullish backdrop. Particularly, the actions of the Fed which is cutting rates like it is going out of fashion to avoid a deflationary downturn in the world's biggest economy.

Interest-rate cuts that have driven a dollar decline and is leading to a surge in liquidity in emerging markets such as China and the Middle East. Oil price rises are not having an impact on demand here as these governements insulate consumers from rising prices with subsidies and price controls. And so the inflationary spiral continues.

And with such an outlook it should come as no surprise that oil (and other hard assets) are benefiting from a quest by investors for assets that are not correlated to the broader (volatile) markets.

So given the above it should not come as a shock that oil investors expect prices to remain above US$100. Every futures contract until December 2016 finished last week above the magic three figure mark.

At the start of 2007, we re-iterated the view that we have held since 2001; that is, that the price of crude oil would reach US$100 a barrel.

As we noted previously these views were scoffed at by other 'market experts' on numerous occasions (mind whether all these can still be called experts following the sub-prime debacle is debatable). Investment banks for instance were still using US$30 oil prices in their valuation models.

And it seems they have still not caught up with the game completely. We note that many energy companies continue to trade at compelling multiples. In our view the share prices of quality energy stocks will undergo a re-rating over the net 12 months, and play catch up once it becomes completely apparent that the oil’s Membership of the 100 club is for keeps.

Until then we believe that this divergence creates an excellent opportunity for investors to acquire natural resources stocks at bargain prices

Overall we continue to maintain an overweight stance to the energy sector, its relative out performance, and defensiveness against the broader market.