With oil
near record highs, climbing to more than US$75 a barrel this
year, the idea that the oil price will drop below US$50 anytime
soon is becoming increasingly difficult to justify. The first
quarter of 2006 makes a good case that the new price range
for oil is more likely to be between US$55 and US$70 a barrel.
While this may not be good news for consumers, high oil prices
are very good for oil companies and those who invest in them.
The price
of crude oil is the engine that drives the energy industry.
Despite its handsome price appreciation in recent years, the
energy sector maintains one of the lowest price-to-earnings
ratios around. The total P/E on the energy sector is only
10.4, versus 15.4 for the S&P 500, based on expected earnings
for 2006, making it one of the cheapest sectors in the S&P
500.
Adding
to an already devalued energy sector, many Wall Street analysts
continue to use US$45/barrel oil or less when they set their
target prices for oil stocks. Citigroup Global Markets, for
example, recently raised its forecasts for oil prices in 2006
to US$60/barrel but is still using US$45/barrel oil to set
its price targets for oil stocks.
Not only
does the energy sector represent good value, it also has the
highest expected growth rate, according to Thomson, the financial
research company. Economic growth in the US and most developed
countries is highly correlated with energy use. In simple
terms, economic growth requires an increase in energy consumption.
This is
particularly true of the less energy efficient economies which
require much higher energy inputs per unit of economic growth,
including China, India, Malaysia, and several other dynamic
Asian economies undergoing rapid industrialisation.
Over the
last five years China has seen its economy grow at an incredible
pace of more than nine per cent. For 2006 it is estimated
that the country will again grow at near double digit rates.
India, another dynamic economy, has seen its economy grow
at a rate of six to eight per cent over the last few years,
and it is expected to grow nearly eight per cent in 2006.
Due to
the dynamic nature of the Asian economies, the incremental
demand for energy—and specifically crude oil—is
skyrocketing. Figure 1 illustrates the incredible demand increases
from China in the last decade. Note that China’s oil
production, while not declining, has not kept pace with demand
growth.
While
global demand for crude oil is growing at an impressive rate,
and is expected to increase steadily over the next 20 years
(see Figure 2), the incremental growth in world oil supply
has not kept pace. The excess supply which as recently as
five years ago stood at around five million barrels per day
has almost disappeared.
By 2007,
the IEA expects the global demand and supply for crude oil
to be equal for the first time in history (see Figure 3).
Without
any legitimate substitutes for crude oil in the global transportation
sector, short term demand is inelastic and as it approaches
supply limitations, prices become much more volatile and tend
to trend upward. Crude oil supply disruptions in Iraq, Iran,
Nigeria and Venezuela are beginning to have a much larger
influence on the price of the commodity and this trend is
likely to continue as the world becomes increasingly dependent
on oil from these politically unstable countries.
Over time,
the high oil price will encourage exploration and new production
but projects to increase production from non conventional
sources have long lead times. Short of a major global economic
slowdown, oil prices should stay high during the next few
years before companies add crude output and refining capacity.
The higher
prices have already reached most of the industry—producers,
refiners, pipeline companies, equipment makers and oil field
service providers—which have all enjoyed new profits.
Leading the charge are the world’s largest integrated
oil companies: Exxon Mobil, BP, and Royal Dutch/Shell. Last
year Exxon Mobil, the world’s biggest oil and gas stock,
recorded the largest profits on record for an American corporation.
Aggressive
independent exploration and production companies such as Apache
Corp and Occidental Petroleum are also well-positioned to
take advantage of improving prices.
Apache
will benefit from growing concerns about political turmoil
as investors start paying a premium for stocks with reserves
in safe places and Occidental Petroleum’s high oil leverage
should provide strong margins in light of continued pressure
on North American gas prices.
Investing
in oil-service and oil-production stocks is an effective way
of benefiting from rising oil prices since the primary driver
of oil-stock prices is the price of crude. The best proxy
for analysing oil stocks as a sector is probably the Amex
Oil Index, or XOI, currently comprised of 13 major oil stocks.
It is designed to track widely-held corporations involved
in the exploration for, development of, and production of
petroleum.
Over the
last 20 years, the correlations between the XOI and oil have
averaged 0.85. When this correlation is squared, it yields
an r-square value of 72 per cent which implies that 72 per
cent of the daily price moves in the XOI over the past 20
years are likely predictable by the parallel daily price moves
in crude oil. In other words, as goes crude, so ought to follow
the XOI (see Figure 4).
This relationship
between oil and oil-stock prices is even strengthening as
the correlations have been trending higher, averaging 0.93
or 86 per cent over the last 12 months.
For the
more sophisticated investor, new avenues for commodities investing
are emerging in the form of exchange-traded funds. Exchange-traded
funds, as you may know, trade just like regular stocks and
are becoming increasingly popular as a substitute for index
mutual funds.
Unlike
conventional mutual funds which discourage frequent trading,
ETFs are useful for traders who want to quickly move into
and out of particular industries or other market segments.
Energy ETFs like the Oil Service HOLDRS Trust ETF and iShares
Dow Jones Energy ETF consist of shares in major oil and gas
service corporations, exposing investors to top performance
and diversification within the entire industry for smaller
fees and commissions than the average mutual fund.
Recently,
the first exchange-traded fund that tracks oil prices became
available as a legitimate candidate for long-term investors.
The US
Oil Fund tracks the movement of West Texas intermediate crude
oil futures, which is the US oil price benchmark. Because
oil is traditionally traded via futures, the fund continuously
buys the shortest-term futures contracts available to track
oil prices closely.
However
you choose to harness the power of the bull run for oil, we
think oil prices must remain strong in the medium term to
encourage further investment in production, which should benefit
all investors with exposure to the energy sector. Unlike gold,
oil has core material value entwined with economic activity
across the world and is not a luxury item or gauge of investor
fear.
There
may indeed be, as the oil bears argue, a risk premium of about
US$10 to US$15 a barrel in the current price of oil related
to political tension. The risk premium in oil, however, looks
very permanent in light of the increasing political uncertainty
of supply.
The
only way to guard against the possibility of even worse supply
disruptions and the negative impact subsequent oil price hikes
will have on corporate profitability in the broader market
is by making sure you have some oil stocks in your portfolio.
Claire Fletcher
is the international equity trader at West Indies Stockbrokers
Ltd and can be reached at 625-WISE or clairef@wisett.com.
Petroleumworld
not necessarily share these views.
Editor's
Note: This commentary was published by The Trinidad
Express, on Thursday, May 4, 2006. Petroleumworld
reprint this article in the interest of our readers.
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Petroleumworld
05 04 06
Copyright
© 2006 Claire
Fletcher.
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