Is oil headed higher?

In case you hadn’t noticed, oil is on the march again. After peaking at $145/barrel in July 2008, oil futures prices on the New York Mercantile Exchange (NYMEX) plummeted down to earth during the latter part of the year, settling at $33/barrel just before Christmas. While this was the focus of much media attention, what has been less well publicised is the steady uptick in oil prices since then, with a first quarter peak of $54/barrel on March 26. This represents a 63 per cent increase in the oil price from those December 2008 lows, something that in normal times would have garnered a great deal of media attention and public outcry. By way of reference, during the entire 1990s the oil price never breached $50/barrel, so in that context even current prices appear pretty challenging.

So what is driving this inexorable rise? It seems unlikely that the demand side is much of a factor, with most developed countries around the globe either in a recession or facing the prospect of one. Having said that, demand has not exactly fallen off a cliff either. While most developed economies are likely to see a contraction in output in 2009, others such as China are expected to experience modest economic growth. The US market, which still accounts for 25 per cent of world oil consumption, has seen demand weakness since late 2007 but this has shown signs of abating more recently. The International Energy Agency (IEA) estimates that global demand for oil in 2009 will decline by a meagre 1.5 per cent compared to 2008 levels. It seems most likely on the demand side that futures markets factored in a very hard landing and a prolonged recession (or even depression) for the global economy with a commensurate slump in energy demand. While the reality has been and remains not far removed from this situation, the truth is that it has not been accompanied by a massive slump in demand for oil. This has caused market participants to reset their expectations somewhat.

The other factor to consider of course is the supply side of the equation. The key variable here is the ability of members of the Organization of Petroleum Exporting Countries (OPEC) to co-ordinate to limit supply in an effort to maintain pricing power. OPEC members agreed late last year to trim production by 4.2 million barrels a day (mbpd) and so far they have been successful in removing 3.3mbpd from the market, achieving close to 80 per cent compliance with much of the cuts being driven by Saudi Arabia. This is pretty good by historical standards – in the past, cheating on production cuts among OPEC members had been commonplace and what is even more interesting is that member countries are resisting the temptation to cheat at a time of global slowdown and tight credit markets.

Aside from OPEC considerations, it is also worth noting that non-OPEC supply (the majority of the world’s oil supply) is likely to be flat in 2009 compared with previous expectations of modest growth, with increased North Sea production being offset by disruption in crude output from Azerbaijan. A third factor to bear in mind is the potential risk of supply disruption due to geopolitical events (think Middle East tensions) or natural disasters (hurricanes or earthquakes).

Beyond short-term supply and demand dynamics, investors would probably be wise to analyse the long-term outlook. According to a report released by the IEA late last year, crude oil prices are expected to reach $200/barrel in nominal terms by 2030 if consumption and supply trends continue on their present trajectory. It is worth noting that the agency’s analysis the previous year pointed to $108/barrel oil by 2030, so they actually raised their forecast in the face of short-term cooling in demand and supply constraints.

So if you believe that the oil price reached a bottom in December 2008 and is likely to trend upward from there (albeit likely with some pullbacks along the way), what should you be buying? If one looks at past cycles, the energy sub-sectors that tend to perform best in an oil bull market are Equipment & Services, Drilling and Exploration & Production. Possible names to consider in this context include Transocean Ltd (RIG) from Drilling, Schlumberger (SLB) from Oil Services, and Marathon Oil (MRO) from E&P. Those seeking more diversified exposure to these themes might wish to consider Oil Services HOLDRs Trust (OIH) as an alternative way to gain exposure to Equipment and Services names, while SPDR S&P Oil & Gas Exploration & Production ETF (XOP) could be used as a proxy for E&P exposure.

 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.  

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