Why the rampant crude oil price cannot be stopped

Why the rampant crude oil price cannot be stopped

By: Fat Prophets

Oil prices have continued their inexorable surge, firming above US$90 per barrel this week to hit a fresh record of $96.24 per barrel in trading on Thursday.

Does this surprise us? The answer is quite simply, no.

While geo-political tensions and lower-than-expected inventory levels might have driven the recent rally, there have been factors at play in the oil market over the past decade, including the emergence of China and the decline in the rate of discoveries that have put all of the foundations in place for an oil price boom.

Furthermore, we maintain our view that further price increases are not only sustainable, but indeed inevitable, over the longer term.

We have essentially been on a crusade since the latter part of 2006 to raise awareness about stockmarket opportunities in the oil sector.

Why were we doing this? Well, as we have previously pointed out, we believed that this may be the last great buying opportunity in oil stocks.

During the latter part of 2006 and the early part of 2007, it seemed as though everything had conspired against the Fat Prophets view on oil.

Believe it or not, media reports were full of gloom and doom regarding oil. Prices slid to a low of just under US$50 a barrel and there were predictions by some market watchers that crude would fall to as low as US$30 within months!

Crude oil did indeed make a very inauspicious start to 2007, with prices falling by more than 30% over a six-month period. As we pointed out at the time, for the nervous-nellies, bears, doubters and trend-followers, there was ample superficial evidence that the oil bull market was over.

However, if one digged just a little deeper through all of the circumstantial evidence, it was clear that very little in oil markets had actually changed. It was essential for investors to appreciate the broader picture.

And what did this tell us then, as it still does now? The world continues to consume oil at a much faster rate than it is replacing it, whilst concerns about existing supplies continue to grow in a deteriorating geopolitical climate.

When oil hit US$50 a barrel the facts showed that the US had experienced one of its warmest winters on record and inventories had built up, putting downward pressure on oil prices. Would this situation last? The answer was clearly no, with inventories disappearing quickly as we had predicted during the US summer driving season.

Market watchers had also dismissed a second major factor, OPEC. In fact, many so-called experts were extremely disparaging about OPEC’s ability to maintain supply discipline. OPEC however stuck to its guns and its production discipline has surprised the market, resulting in an extraordinary rebound in crude prices.

So concerned have oil markets become that oil prices have hit record all-time highs (both in actual and inflation-adjusted terms) of above US$96 a barrel.

And the situation is going to get worse before it gets better.

Oil prices normally take a breather about this time each year due to a seasonal lull in demand, before picking up again with the onset of the northern hemisphere winter. But we believe there are real concerns about inventory levels heading into winter – i.e. is there enough crude available to fully meet winter heating oil demand?

Markets obviously share our concern, with prices around 55% above the level at the same time last year. In fact they are rising when they would normally be dropping.

And the outlook is not going to get any better.

A key driver of the surging oil price remains the unrelenting rise in global energy demand. Over the last fifty years, oil consumption has grown enormously, from 10 million barrels to a massive 86 million barrels per day. And this situation is not going to ease up; with the Energy Information Administration forecasting oil demand will rise to around 120 million barrels per day by 2030.

The primary reason for this demand surge has been the inexorable rise of the Chinese economy. China’s oil consumption has grown at an average rate of 7.5% annually over the past few years, seven times higher than the US. Almost 40% of last year’s oil consumption growth was due to Chinese demand and the country now consumes 9% of global production.

Even so, per-capita oil consumption in China remains extremely low compared to many other countries. In fact, US per capita consumption is 14 times that of China. While the catch-up will take years, China’s burgeoning middle class will lead to an upsurge in oil demand.

The other emerging country to underpin demand for oil is India, currently accounting for just 3% of global oil consumption and also shaping as a key oil consumer in decades to come.

These two emerging nations account for around 12% of global consumption, which is about half that of the US. Given their rapid growth rates, we believe oil demand coming out of these two economic powerhouses will in time be enough to act as an offset to any US weakness.

With demand growing strongly, global production (supply) is not keeping pace. The ability of global producers to respond to increased demand is compromised by the fact that there is very little spare capacity, and higher prices are needed to entice a supply response. This is largely because most of the world’s easily accessible and cheap oil reserves have already been found.

While there may still be relatively large reserves of oil remaining, this oil will be more costly to find, extract and bring to market. Effectively, commercialisation of these resources will only be viable at a higher oil price.

Therefore, it does not matter whether one is a subscriber to the ‘peak oil’ theory or not. The effect is exactly the same. Higher oil prices are here to stay.

There are two other crucial supply-side issues that we believe will have a long-term impact: lack of exploration spending and energy nationalism.

The oil industry suffered from a lack of exploration spending for a period of at least a decade, when risk-averse executives found it cheaper to buy oil reserves (through takeovers and buyouts) than exploring for them. This was a short-term panacea of course, because eventually reserves would start to decline as the rate of new oil discoveries dried up.

The consequences of these actions are being felt a decade later, with no truly world-class new oil fields on the development horizon.

Energy nationalisation is also a key emerging issue in the 21st century. In effect, governments around the world are becoming more protective of their own domestic energy resources, in some cases implementing foreign restrictions on ownership and investment.

But it doesn’t stop there. Many national oil companies, for example those in China, are actively scouring the world to secure reserves for future production. Africa is rapidly becoming the battleground in this battle between west and east.

Nationalised oil companies do not necessarily play by the same rules as their privately-owned peers, as their goals are not simply motivated by profit. Western companies increasingly find themselves outbid worldwide by national oil companies. The primary goal of these national oil companies is energy security, with profit featuring perhaps well down the list.

This competition will only help fan tensions and push oil acreage and project valuations to escalating heights.

Let us not forget the impact of OPEC and the Middle East. OPEC’s role in influencing oil prices is also significant. The cartel accounts for 40% of global oil production and holds two thirds of the world’s oil reserves.

The Middle East region is fraught with difficulties from a geopolitical standpoint. Recent flare-ups have involved Turkey threatening to move into Northern Iraq to launch an attack against the PKK (Kurdistan Workers Party), in retaliation for the deaths of Turkish soldiers along the border region. Exacerbating regional tensions, the US and Iran are at it again.

Right now, there is deservedly a large geo-political premium built into the oil price and further pressures will push prices well past US$100 per barrel.

Looking beyond geo-politics and the demand and supply dynamics of oil, we also find support for further upside in the weakening US dollar. The oil price and the value of the greenback typically move in opposite directions. The latest US interest rate cut this week has exacerbated the situation.

Given the limits to production, the scarcity of new reserves and the rampant rise in demand, we believe the oil price will easily breach our long-term target price of US$100 per barrel in the coming weeks, with inevitable increases to US$150 a barrel and beyond over coming years.

IMPORTANT: This message, together with the Fat Prophets website (www.fatprophets.com.au) and all its contents have been prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore talk with their financial planner or advisor before acting on any information present on this message or the Fat Prophets website. Performance is hypothetical and based on recommendations made in the Fat Prophets report. The table is updated monthly. Transaction costs have not been taken into account. Past performance is not a reliable guide to future performance, and investors should be aware that returns can be negative. For a full explanation of the performance calculation methodology, please contact Fat Prophets.

Fat Prophets are leading independent stock market advisors. Our aim is to be transparent, accountable, objective and ethical. We believe integrity is the central characteristic of every successful investor. Our independence in financial markets is derived from the fact that we do not execute share transactions or provide investment banking services. fatprophets.com.au

Article Source: http://www.ArticleBiz.com