Should investors stick with oil?

Craig Pennington, Schroders' global energy analyst, talks about the reasons behind the recent oil price increases, where he thinks oil markets are headed and whether investors should maintain an exposure to the industry.

The price of crude oil has breached the $67-a-barrel mark and continues to dominate headlines in both financial and mainstream media outlets. What's behind the most recent rises?

In the short term, traders have been preoccupied with the gasoline (petrol) market. We're in the middle of the summer driving season, when gasoline demand from the world's largest consumer, the US, peaks as Americans take their cars on holiday. The structural theme in this market is a lack of investment over the past five to ten years - there are shortages of supply in both upstream (exploration and production) and downstream (refineries) which, when coupled with increased demand, has put pressure on prices. Looking at refineries, in particular, heavy utilisation has increased activity to very high levels which has caused accidents on an almost weekly basis recently and halted supply. Gasoline inventories are subsequently at low levels.

Another factor is the renewed risk of terrorism. Recent warnings about potential attacks in Saudi Arabia have increased tension, while the resumption of uranium conversion activity in Iran, the second largest producer in OPEC (Organisation of Petroleum Exporting Countries), is also playing on investors' nerves. Many suspect that this renewed atomic activity is the first stage in Iran's attempt to build a nuclear bomb. Any political fallout from tension between Iran and the US - sanctions or a military strike, for instance - would cut supply and lead to further spikes in prices. The recent election of a hard line Iranian president suggests that this threat is likely to be around for some time.

What about in the long term? How have we got from oil being $15 in 1998 to well over $60 today?

Looking further back, the question might actually be: why did oil reach $50 in 2004, never mind $60 this year? It's largely to do with lack of investment. When oil prices collapsed in 1998, capital expenditure on exploration and production was reined in as companies attempted to present balance sheet discipline to shareholders in the face of a low oil price. At the same time, companies were negatively surprised by decline rates in the North Sea and the US, both mature markets, and were slow to move production to non-OECD (Organisation for Economic Co-operation and Development) markets. This was partly due to the risks involved operating in what can be less stable regimes with less mature corporate structures, but also because these new areas were expensive to develop as a result of their distance away from home markets. OPEC countries such as Saudi Arabia and Iran didn't increase investment when prices were low, either. Their national budgets, largely reliant on oil revenues, had suffered.

Also, they had and continue to have young populations and not very well-diversified employment sectors - unemployment was high, which meant social costs were also high. Countries did not have the money to invest in new production. In addition, OPEC already had spare capacity as its global share of oil output was falling. Again, this provided little incentive to expand capacity. So the oil industry underwent a period of low investment. This, in itself, might not have caused such a spike in prices if global GDP growth had not been quite so strong over the last two years. However, demand for oil grew ferociously in 2004 because of a synchronised global economic recovery. We saw a recovery in growth in major developed economies, at the same time as structurally stronger growth in demand from China and India, both net importers of oil. What was already a tight supply situation got worse overnight. The lack of investment in new resources coming on stream combined with a sharp increase in demand put enormous pressures on prices.

What's the situation going forward? Do you think markets can tighten further in the fourth quarter and 2006?

The market remains paranoid. There is little spare capacity in OPEC countries. If there is a major supply disruption - be it in Iraq, Saudi Arabia or even Venezuela - it is unclear how OPEC will respond. Another factor on the supply side is the hurricane season, which can last through to the end of October. We've already seen numerous hurricanes in the Gulf of Mexico disrupt inventory building. The level of inventory draw-down (ie., how much oil is used) will be affected by how cold a winter we have, particularly in the North Eastern area of the US where demand is strong during the 'heating season'. Although heating oil inventories are looking OK at the moment, markets are jittery. Add in geopolitical risk from the Middle East and prices may shoot up further.

Non-OPEC supply continues to disappoint. An example is the difficulty BP has had with its Thunderhorse rig. Supply was expected to come on stream in the fourth quarter of this year. There have been some major technical problems, however, which means we're unlikely to see it coming on stream until next year at the earliest. On the demand side, growth continues to be high, in spite of increasing energy prices. The US economy is looking healthy, so we might see a growth in demand as their economy ticks along stronger. So, while there is a chance that markets will ease between the end of the driving season in the US and the start of the heating season, you have to say that it's entirely possible that markets tighten in Q4.

What effect will any tightening have on global demand?

It's very difficult to say. Continued gains should have an effect on demand as a high oil price is basically a tax on consumption. It could affect many sectors: for example, retailers are paying more to have their goods delivered to their shops, chemicals companies are incurring higher production costs, factories are looking at higher running costs. European manufacturers are already vocally complaining about the cost impact of a higher oil price. The question is how long will companies be able to shield consumers from higher prices - how long will it be until the increase in prices is passed through to the consumer?

Having said all this, the impact of high energy prices will have less of an impact today than it had during similar periods of spiralling prices, for example in the oil crisis in the early 1970s. This is mainly because of increased energy efficiency and a decrease in oil consumption as a percentage of GDP. Energy costs have come down significantly since the early 1970s. The major economies in the world - Japan, the eurozone and the US - are far more energy efficient than they were. Consumers are not feeling the impact of price increases as much as they used to - for instance, there are relatively high levels of tax on petrol at the pump. Also, certain Asian economies like Indonesia and China, both net importers of oil, have minimised the impact through the use of price stabilisation funds which are designed to reduce the volatility of the oil price. Above all, consumers seem resilient. Fuel costs are up, but the actual impact has not been that great. For a dramatic change in demand, we'd have to see a huge rise in prices.

Should investors be maintaining a high exposure to energy-related stocks in their portfolios?

Although the sector has been a top performer during 2004 and so far this year, we still see scope for upside gains. Particularly attractive at the moment are the onshore gas companies in the US. There is a shortage of natural gas in the US - domestic production is in decline and imports from Canada are decreasing. Companies likely to benefit from this tight supply situation include Ultra Petroleum, EOG Resources and Quicksilver.

In Europe, meanwhile, given the recent run-up in prices and positive relative outperformance it would not be entirely surprising if we see a pausing for breath in the shares of oil majors such as Royal Dutch, ENI and BP. That said, compared to other areas of the market, these companies are generating substantial amounts of free cash flow which is being returned to shareholders through high dividend growth rates and share buybacks. Valuations are undemanding relative to other areas of the market, so we still view European energy stocks as a good place to be.

Are oil services companies a good way of playing a high oil price?

There are some very attractive opportunities in the oil field services space, yes. Oil services companies are core beneficiaries of increases in capital expenditure by oil majors as they look to increase supply. It is a particularly good time in the cycle as the capacity in this area is increasingly tight - consolidation in the oil services industry in the late 1990s means there are now fewer players in the market to satisfy higher levels of demand. So pricing power is strong with oil companies less able to say no to price increases. Higher day rates are being charged, while the length of contracts with oil services companies are being extended. Importantly, while the industry has been volatile in the past, with capacity having been built up too quickly, managements are now being careful not to build up excess capacity. Examples of good plays include Nabors, BJ Services (both US), Wood Group and Sondex (both UK).

What are the main risks facing the oil industry?

The biggest challenge is access to resources. Most residual resources are in countries in which companies either don't want or are not allowed to operate. The Middle East remains difficult for western companies. While in Latin America, as long as the good times roll in the oil markets, certain regimes want a slice of the pie. Governments in countries such as Venezuela and Bolivia are ignoring contract sanctity, raising taxes and also claiming back taxes on profits. With the oil price so much higher than when contracts were first agreed, governments are trying to rearrange and claim more. For example, Spain's Repsol has had difficulty in Bolivia, where a large part of its reserves are located. The government has recently raised taxes to 50%, which will impact Repsol's ability and desire to do business there. We may see companies withdrawing from countries that charge them such high rates, which could negatively impact global supply growth.

Other risks include Iraq - how do you operate there? Also, will Saudi Arabia ever really open up to western oil companies and is Russia closed off to foreigners, now that the government is increasing its control of the market?