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 MARKET REPORTS |
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Analyst report - shares
Oil rising to the top… again
August 2, 2007
Brendon Lau, ShareAnalysis
 Crude oil is threatening to break fresh highs after hitting a peak of over US$77/barrel last July, and this has propelled the Energy sector up by almost 20% in the past six months, making it the second-best performing sector on our stock market. If you think the buying opportunities are all gone, think again.
We remain positive on oil-related stocks because the factors that pushed oil to record highs last year have not disappeared—supply remains tight while demand is booming. In fact, most people might be underestimating the global demand for oil. The International Energy Agency (IEA) recently published a report that predicts a supply crunch after 2010 as oil cartel OPEC runs out of spare production capacity.
Furthermore, IEA expects global oil demand to expand 2.2% a year, reaching 95.8 million barrels a day by 2012, up from 86.13 million barrels a day this year. The forecast is based on global economic growth of about 4.5% annually. The interesting thing is even if global growth slows to 3.2%, it will only mean a year’s delay before OPEC runs out of spare capacity.
If you thought 4.5% annual growth is too optimistic, you will be surprised to know that the International Monetary Fund (IMF) has upped its forecast on economic growth and is now expecting the global economy to expand at an annualised pace of 5.2% for the next 18 months. This would mean that the world economy is enjoying the longest period of growth since the 1960s.
Meanwhile, on the supply side, ever-present geopolitical tensions and refining bottlenecks are supporting the high oil prices, although it is widely believed that there is no absolute shortage of crude oil, at least not in the immediate future. The ominous sign though is we are not finding enough new oil reserves to keep up with expected growing demand.
For these reasons, we have recently upgraded our long-term oil forecast to US$55/barrel, which we use in evaluating oil stocks. This has positively impacted the oil stocks we cover, although our revised exchange rate assumptions are offsetting some of this gain. Santos’ (STO's) recent production report is a case in point. Its 2Q07 production was 7.6% higher than that of 1Q07, but its revenues were 8.3% lower. The weak US dollar led to a 10% decline in realised Australian dollar oil prices. The exchange rate remains one of the biggest risks to the sector. Another risk is the inflow of professional funds into oil as these funds seek new asset classes to diversify into. Fund movement is likely to add to further volatility to oil prices. Falling crude prices and an appreciating Australian dollar will be a double whammy to many of our oil stocks.
However, these risks are somewhat cushioned by our relatively conservative oil price forecast when compared to recent comments from OPEC, which indicated that US$60-65/barrel is a “fair price”. This is likely to provide a medium-term floor on the price of crude. This fair price seems to have moved up from six months ago when it was believed that OPEC would defend the US$50/barrel level. “Fair” is really the euphemism of how much the market is willing to bear.
Feeling for the slippery floor
We believe the days of cheap oil are over. Strong demand, faltering supply and geopolitical tensions will likely see oil well supported at US$55/barrel, if not more. However, predicting where the "floor" (support) is for crude oil is still extremely difficult.
If one had to “guess” though, looking at the highest-cost oil producer could give some helpful insights. This follows basic economics. When prices drop below the cost of the highest-cost producers, these producers will eventually stop supplying the market. This, in turn, increases product scarcity and theoretically drives prices back up.
Some of the highest-cost producers of significance are the oil sands producers in Canada. According to the National Energy Board (NEB) of Canada, Alberta’s oil sands are equivalent to the second-largest oil reserves after Saudi Arabia. Extracting oil from sands though is very resource-intensive. NEB estimates the operating cost for these producers to be between US$9 and US$14 a barrel, compared with less than US$1/barrel for Middle East producers. Supply costs for Alberta’s oil sands producers range from US$36 to US$40 a barrel. Supply costs include operating costs, capital costs, taxes, royalties and the rate of return on investment.
This means the floor price should be somewhere above US$40/barrel when geopolitical tensions and other potential supply disruptions are factored in. Any break below US$40/barrel could put many of Canada’s oil sands producers out of business and this would reduce global oil supply by over 1M barrels a day. While that may only represent a little over 1% of global consumption, it is probably enough to send shock waves through the already-nervous oil market. Furthermore, output from Canada’s oil sands region is expected to grow in significance, as production is forecast to triple by 2015.
The risk to supply cost is on the upside. Like most industries, oil sands producers are facing increasing costs, primarily due to labour shortage. The price of natural gas is also another concern, as this is required in the production process. The oil sands industry uses about 21M cubic metres a day of natural gas, or about 5% of the Western Canada Sedimentary Basin production. NEB expects this to rise to 12% in less than a decade.
What all this means is the floor price of oil is more likely to rise than fall—bad news for motorists, transport companies and plastics manufacturers. Oil consumers here better keep praying the Australian dollar stays high against the US dollar, as this will help take some of the edge off rising oil prices.
Brendon Lau is the Editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. For more information on these stocks and for a free trial of its web-based investor research services, please go to the ShareAnalysis website.
More articles from this week's CompareShares newsletter:
Commodities: Nuclear power here to stay
Resident trader: Revenge trading
Lottery winners: The perils of sudden wealth
Superannuation: Getting behind the wheel
CFDs: Volatility highlights strengths and weaknesses
Politics: Backing a winner
Smart Investing: Rising debt levels an issue
Shares: Market depth explained
Stock of the week: ASB
Investing: Oil rising to the top… again
Gold: Gold vs the dollar
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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