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The bull run in oil has hit a slick – the price has fallen 20% since the summer of this year. Is a further collapse in the price on the cards, or is this just a temporary blip?
The oil bulls (those in the MoneyWeek office included) had a thrilling August this year as the oil price soared above $70 a barrel and, for a while anyway, looked like it would stay there. Unfortunately, it didn’t. Today, the bears are back on top in the oil market: the price has fallen to the mid-$50s, 20% below peaks seen in the summer. But we don’t think it’ll stay there long. Might the oil price drop a little more before it turns back up again? Maybe. But will it collapse, as it did back in the mid 1980s, or in late 1998 after the Russian oil default? No way.
The fact that the price has fallen as much as it has in the last few months reflects several factors: sentiment has been boosted by the end of the hurricane season in the Americas; the US summer driving season has come to an end; Opec has been making lots of noise about not cutting production, even as the price eases; and finally a lot of the speculative heat has disappeared from oil to find other markets to disrupt. It is also worth noting, as we did in last week’s Big Picture, that the oil price usually falls around this time of year for various seasonal reasons and then picks up later in the winter. But none of these things can even begin to affect the basic reason why we are pretty sure oil has entered a long-term bull market: demand is high and supply is constricted. Simple as that.
As John Kelly of Abbey points out, the last time the world was threatened with a major energy crisis it was rescued by the discovery of two new oil-producing regions, the North Sea and Alaska. These were both huge finds and, better still, were in politically stable regions. So production from them was fast built up and Opec consequently cut back its own production until it was only running at about 60% of capacity. With excess supply knocking around (Opec couldn’t cut back too much – its member countries all needed the money), prices then fell in real terms. Problem solved.
But we’ll have no such luck this time round. Production in Alaska and in the North Sea has peaked and production in the rest of the world may well have done the same. Back in 1956, American geophysicist M King Hubbert created a model of all known oil reserves and their lifespans. From this he developed his theory of ‘Peak Oil’.
The idea is that when oil reserves are discovered, production amounts are initially small. Then, as the wells become more efficient, oil production increases. But at some point, a peak output level is reached that cannot be exceeded, even with improved technology. Then, the production slowly decreases as the oil gets harder and harder to extract. Finally, it becomes uneconomic to continue drilling at all.
In 1956, Hubbert predicted that oil production in the US would peak between 1965 and 1970 and world production would peak in 2000. US oil production did indeed peak in 1971, and has been decreasing ever since. And a number of oil-industry experts have calculated that the global production of conventional oil actually peaked in the spring of 2004.
Frightening stuff, but is it really true? We think it might be. Although the Saudis claim to have endless reserves, we have only their word for it, as Matt Simmons, author of Twilight in the Desert, points out. Saudi reserves haven’t been audited by anyone other than themselves since the late 1970s and the same can be said of almost all the Opec countries. After Hurricane Katrina, Saudi Arabia admitted that it was not able to increase production to make up for the loss of Gulf of Mexico oil rigs. That doesn’t sound like the kind of thing a nation with an unlimited supply of oil to hand would say, does it?
Unfortunately, unlimited supply is rather what the world needs. Scores of developing economies – China, India, Russia, and so on – are in growth phases at the same time, and if they want to end up with the same kind of lifestyles as the Americans (which they do), they need oil. Right now, emerging markets use up tiny amounts of oil. China is consuming only 1.5 barrels per person per year and the Indians use less than one barrel a year each. That figure is 10.4 in the UK and in the US, each rampantly consuming resident gets through 26 barrels a year.
What happens when the Chinese all have enough money to own four cars per household, when the Indians decide that they – like the Americans – cannot manage without either air conditioning or heating on all the time, when the residents of all these countries have fully emerged as gas guzzlers and electricity wasters in their own right? At the moment, the world uses up 85 million barrels a day, but according to the International Energy Agency (IEA), demand is going to leap 50% over the next 25 years, to 127.5 million barrels a day. Right now, the world produces a mere 1.5 million barrels a day more than it consumes, so to meet that demand without the price going sky high, the world is going to need to discover a lot more easily accessible oil than anyone thinks likely today.
None of this is to suggest that the world is actually running out of oil. It isn’t. If we’ve just passed peak production, that means we’ve got the same amount left to use up as we have already used up – and we’ve used a lot. But the world has run out of cheap oil. We can extract oil from the shale around the coast of Scotland and we can squeeze it out of the Canadian oil sands, but we can’t do that for $20 a barrel. And getting oil out of conventional wells is getting pricier too: according to Goldman Sachs, the price of pumping a barrel of oil out of the ground has increased by $4 a barrel in the last few years, thanks to the fact that in many of the world’s wells the oil that can easily be pumped up has already been pumped up. This is one of the reasons the broker gave for suggesting earlier this year that the oil price could hit $100. That price seemed silly to many when Goldman Sachs first published it (its competitors had a field day taking pot shots at its analysis), but it doesn’t seem so silly anymore. Demand is high, supply is tight, and that means that the only way for the oil price to go is up. The recent pull back is nothing more than a temporary blip.
The rival view: there’s a bubble in the oil market
There is no doubt that loose monetary policy around the world has been at the heart of the world’s extraordinary economic resilience in recent years. However, it has also bred a series of bubbles – in property markets from Glasgow to Shanghai, in emerging market debt, in the bond market as a whole and, according to some, even in the commodities markets.
But is oil part of this series of bubbles? Morgan Stanley’s Andy Xie thinks so. Moreover, he thinks that the fact that oil has fallen so much since its early September peak is a sign that it may be “the first bubble to burst in the current cycle”: the price by his reckoning could well be back below $40 a barrel in the coming months.
According to Xie, the current supply/demand balance is not as tight in 2005 as it was in 2004. This means that oil prices that are still hovering 50% above the averages of 2004 make no sense at all – and it also suggests that it is not fundamental demand that’s keeping oil prices up, but “demand from financial buyers”.
According to the IEA, says Xie, global oil demand rose by 2.9 million bbl/day, or 3.7% in 2004 – twice as much as the historical average rate of growth, thanks largely to a 15% increase in Chinese demand. As a result, the market thought that “the trend in Chinese demand growth had permanently changed” and so sharply pushed up oil prices this year.
But in fact, Chinese demand has remained pretty static this year, despite the country’s breakneck speed of economic growth. This is because China’s national capacity electricity generation has increased at a faster rate than demand this year, so the number of bottlenecks in the system, and hence the need to use private diesel generators as back up, has declined.
Yet the market kept pushing oil prices higher and higher, looking for any excuse to do so. This, says Xie, “looked to me like financial mania”, caused by buying from hedge funds fed up with low interest rates and anaemic returns in the stockmarket and looking for outsized returns elsewhere. The momentum of the bubble then “sucked in more and more speculators”, but now it is “finally crumbling under its own weight as there are not enough new speculators to sustain the upward momentum”.
So what next? The bears say there will be more oil in the system next year than this year.The IEA forecasts suggest that production capacity will rise by 2.5 million bbl/day next year, but, says Xie, “I suspect that demand will grow by less than 1.5 million bbl/day”. At the same time, interest rates will be rising – something that should cut off much of the speculative investment that has been driving the market. All in all, these two factors will “create the environment for an oil-price collapse”.
Oil stocks for the bulls to buy
If you think the oil price is going to stay high, or go higher, you have to look at investing in the world’s leading oil companies, says Matein Khalid in the Khaleej Times. “These are money gushers”, most of which discount oil prices at only $30-$35 (against their current $52), as well as having “excellent growth prospects and incredibly low valuation metrics”.
One to look at first is Chevron (CVX, $57.4), a “global colossus” that last year earned more ($175bn) than most third world countries, but which trades on a value investors’ “dream” p/e of a mere seven times. The shares also yield over 3% and, according to Bloomberg, have a price-to-growth ratio of 0.63 times, well below the level where value investors usually jump in.
ConocoPhillips (COP, $61.3) is also “incredibly cheap” on a “Cinderella valuation” – its p/e comes in at only six times. Some of this cheapness reflects the fact that its assets in Russia and Venezuela expose it to geopolitical risk, but even taking this into account it looks like the market is being too “draconian”. The investment community has, says Khalid, “thrown the baby out with the bath water”, indiscriminately selling stocks as the oil price has fallen. In doing so, they’ve created a “buying when there is blood on the streets scenario” for those sensible enough to take it.
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Merryn Somerset Webb
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