The outlook for oil

LGT explains why the upside for crude prices is limited.

While we expect oil to remain above $50 a barrel in coming months, it is exceedingly unlikely that oil prices will double or triple through the end of next year as some analysts and ôPeak Oilö theorists would have us believe.

Put simply, the world is awash with oil, and if prices do rise, crude supplies can and will increase and alternative energy sources become more viable.

Although a lack of refining capacity, ageing pipeline infrastructure, geopolitics, natural disasters and the continued emergence of Indian and Chinese economies will underpin prices, the high levels of inventories and supplies mean the upside for crude prices is limited. When prices do trade higher for a sustained period, previously uneconomic oil fields and processes such as refining the oil sands in Canada become viable as do alternative energy sources such as biofuels, wind, solar, geothermal and nuclear.

At the start of this year, our forecast range for crude was $50- to $80/bbl, and it remains intact. Indeed, the price of the front month crude contract on the New York Mercantile Exchange (Nymex) peaked at $78.40 in July, up from a February low at $57.55. In mid-October, the price dropped back to a low at $57.22/bbl.

Some market participants, including Goldman Sachs, talked during the past year of the possibility of prices above $100 on strong demand from China and India, and others of $200 a barrel or more in the longer-term on the scarcity argument, but price movements during the past 12 months suggest these scenarios are unlikely for now.

And one doesnÆt have to be an expert on the ins and outs of global energy markets to understand that prices are probably capped for the moment. Last year, the US Gulf Coast was struck by two devastating hurricanes and price spikes stopped just shy of $80. This year we had the exogenous shocks of: Israel invading Lebanon for the first time since 1982 with the accompanying risks that the conflict could (but didnÆt) widen; Iran resisting calls from the West to cease its uranium enrichment programme; and North Korea reportedly testing a nuclear device and once again price rises stalled at the same level.

All this against the backdrop of ongoing conflicts in Iraq and Afghanistan and around 10% economic growth in China and India and the oil price is still down 24% from its 2006 peak. It is hard to imagine an environment that could be more bullish for oil prices, so the pullback reflects the erosion of some of the ôspeculativeö component contained in energy prices in recent years. It is no coincidence that hedge funds during the past couple of months have taken a beating as oil and gas prices fell.

Oil, having been almost a one-way æbetÆ for much of the past couple of years, was a key source of return for many hedge funds during this period, but the sell-off for many of these firms has been painful. While natural gas price moves arenÆt correlated with oil, it was a massive decline in gas that sent Amaranth LLC to the wall in October with losses approaching $7 billion incurred in a matter of weeks. The point here is that notwithstanding the ongoing synchronised expansion of the global economy, there is a valid argument that prices wouldnÆt have reached the high $70s in the first place if it wasnÆt for these heavily leveraged trading accounts taking ælongÆ positions.

Just as the gold industry has its ægold bugsÆ û analysts and investors who hold the view that the yellow metal will eventually trade at $2,000 an ounce or more in coming years for reasons including inflation û the energy sector has its ôPeak Oilö theorists who maintain that $100/bbl will look like a bargain in coming years as oil production slows and demand continues to increase. They may eventually be right, but as an investor in financial markets, timing of investments and risk management are key, meaning taking positions on oil rising substantially in five-, 10-, 20-, or 30-years is ill-advised and unrealistic. Peak Oil, also known as Hubbert's peak, refers to the peak of the entire planet's oil production. After Peak Oil, the rate of oil production on Earth will enter a terminal decline. The theory, according to Wikipedia, is named after American geophysicist Marion King Hubbert, who created a model of known oil reserves, and proposed, in a paper he presented to the American Petroleum Institute in 1956, that production of oil from conventional sources would peak in the continental United States between 1965 and 1970, and worldwide within "about half a century" from publication. To be sure, oil is a non-renewable resource, but it would appear that we are some distance from reaching such a point. While recent data from the OECD show oil output has been fairly static for the past 20 months, this isnÆt evidence that Peak Oil is nigh as the numbers are skewed because most major crude producers are members of the OPEC cartel, which increases or decreases supply as it sees fit. An estimate by the US Geological Survey shows Earth has more than three trillion barrels of conventional recoverable oil resources of which around one-third have been extracted.

While these USGS numbers are (and can only be) estimates, it is difficult to make a compelling argument that output is, or will soon be, in a terminal decline if the market was allowed to move solely on the basis of supply and demand.

Oil companies dismiss Peak Oil, saying it isnÆt supported by hard data, and that it only returns to the mainstream when prices are high. For example, the chairman of Exxon Mobil CorpÆs Australian unit, Mark Nolan, last month told an Asia-Pacific Oil & Gas Conference that peak oil predictions have been occurring regularly since the 1920s. He says the supplies of fossil fuels are abundant, and that industry and society have always underestimated resources. ôThe world has an abundance of oil and there is little question scientifically that abundant energy resources exist,ö Nolan said. Adherents to peak oil theory believe global production peaked in the past several years and output will likely decline in coming years, falling by about a quarter by 2020 from current global oil consumption of 86 million barrels a day.

Nolan cited the USGS numbers, adding that conservative estimates of heavy oil and shale oil resources push the total to 4 trillion barrels. Moreover, a 10% increase in recoverability will deliver an extra 800 billion barrels. ôWe have reason to believeàthat the end of oil is nowhere in sight," he said.

So with supplies clearly not about to run out, prices running into a proverbial brick wall at $80/bbl, and OPEC likely to defend the $50- to $55/bbl level in our view, it would appear that prices are likely to remain range-bound into 2007 with a slight bias to the downside.

Benjamin Pedley is investment strategist with LGT Bank in Liechtenstein (Singapore). This article first appeared in the Winter issue of Asian Private Capital.
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