With the fluctuations in the price of crude oil over recent months, many oil bulls could be forgiven for feelings of extreme nervousness. For those with short memories, it is worth remembering that there were similar price movements in oil markets a year ago, yet prices went on to hit all-time highs of more than US$78 a barrel during mid-2006.
Crude oil ended its four-year rally during 2006, as record-high prices slowed demand growth and less extreme weather boosted supplies. Oil prices in 2006 ended pretty much where they began, which contrasted to a 40 percent surge in 2005 and a 36 percent rise in 2004.
Growth in global oil demand slowed from 1.5 percent to 1.1 percent over the year and storms spared US Gulf platforms battered by Hurricanes Katrina and Rita in 2005. Now, the US is experiencing a warmer than usual winter, further weakening seasonal demand.
Following such rapid appreciation in 2004 and 2005, it was not altogether surprising to witness a consolidating oil price throughout 2006. Given the events of the past few weeks, the consolidation period may have longer to play out.
Negative sentiment has dominated crude oil markets since the start of the year, due to short-term issues relating to warmer-than-expected weather in the US and a corresponding build in crude oil inventories. There has also been scepticism with respect to the credibility of recent OPEC supply cuts.
Rather than focus on these shorter term issues, we believe investors should take a more measured view of the oil market.
Firstly, we are of the opinion that the recent crude inventory build in the US is a short-term event, with oil markets remaining just one supply hiccup away from US$65-$70 a barrel. Furthermore, we do not share the same general market scepticism of OPEC production discipline, as we believe the organisation has a demonstrated recent track record of its ability to co-operate, implement and maintain output cuts.
Oil markets had built in a substantial risk premium of around US$10-$15 a barrel into prices during 2006, based on potential supply interruptions from both the US hurricane season and the Israeli-Lebanese war. Contrary to the fears of the market, both events were fizzers and had virtually no impact on crude oil supplies. In our view this premium has now been completely unwound, despite significant supply risks remaining.
We believe it is essential that investors take a step back and look at the broader picture. That picture shows the world consuming oil at a much faster rate than it is replacing it. With oil consumption running at around 85 million barrels a day, annual consumption is now over 31 billion barrels of oil! Where are the new fields to sustain such consumption, when these days a find in the vicinity of a couple of hundred million barrels is noteworthy?
"We believe consumption in China and India will continue to increase during 2007, helping to offset any US based consumption slowdown."
The truth is that oil companies have already found most of the 'easy oil' available in the world over the past century. While there may be vast reserves left, the extraction of this remaining oil will almost certainly be more challenging from a technical point of view and involve a higher cost of extraction and production.
As a result, the bottom line is that higher prices will be needed to justify commercial development of these new fields. Either way, world oil markets must face the harsh reality of higher prices for the oil that we have now and even higher prices to develop the more costly and more inaccessible fields of the future.
We believe a picture is worth a thousand words, and as such, we pay close attention to the charts. This is particularly true in times of volatility and greatly diverging opinions on where oil prices might be heading. In coming months we expect oil to trade within a range between US$50 and US$70 per barrel.
However, in the absence of a global recession, we believe sharply higher prices are likely in the years ahead.
The longer-term rise in oil prices has been characterised by a series of firm advances followed by short-term corrections. This type of price action is typical of long-term upward trends. The corrections prevent prices from getting too far out of balance and ultimately improve the sustainability of the upward trend.
In the near term, we believe the correction from July's all-time high of US$78.40 is virtually exhausted. Just as buyers can become irrationally exuberant at market highs, sellers can become excessively pessimistic during corrections. The market can become so obsessed with short-term factors that prices can overshoot on the downside.
We attribute a large proportion of oil's recent price weakness to the unwinding of speculative positions. Oil's strong run over recent years has naturally attracted the attention of a large number of speculators. We have seen similar strong speculative buying by investors across the entire resources sector, and in all commodities.
However, once upward momentum wanes, speculators typically head for the exits, creating volatility in the process. The increasing participation of hedge funds has also exacerbated this price volatility.
Despite these short-term movements, we believe the geopolitical environment will place a long-term floor under the oil price. In particular, we continue to watch developments in Iran very closely.
Despite seemingly disappearing from the media spotlight over recent months, Iran continues to press ahead with its nuclear ambitions, much to the chagrin of the US. We believe this will re-emerge as a major geopolitical issue during 2007.
Already, Israeli officials have had to deny claims that they intend bombing Iranian nuclear facilities, almost certainly with tacit US support. If the claims are true, then such a military exercise could lead to a dramatic escalation of tensions within the region.
The Middle East remains America's Achilles Heel and will be for years to come. It contains the vast majority of the world's cheap oil. The US currently imports around 60 percent of daily oil requirements, highlighting a significant dependence on foreign oil. Consequently, we believe the oil price should include a significant risk premium, as it is the lifeblood of the US and global economies.
"Following such rapid appreciation in 2004 and 2005, it was not altogether surprising to witness a consolidating oil price throughout 2006. Given the events of the past few weeks, the consolidation period may have longer to play out. "
With no end in sight to the region's geopolitical issues and with the potential for them to grow in intensity, we believe a higher risk premium will be factored into oil prices during 2007.
After all, oil is a strategic resource with no attractively priced substitute. In the event of heightened geopolitical tensions, oil importing countries such as China and Japan will pay up for energy security. Unfortunately for the West, its reliance on Middle Eastern oil is going to rise, not fall, over the coming decades.
The Middle East is not the only oil-producing region with problems. Nigeria, which hosts Africa's second largest reserves after Libya, is suffering from more regular and violent militant attacks on its oil industry. The security situation constantly threatens its oil output. The rising issue of 'energy nationalism' is something the oil market is going to have to confront increasingly in 2007.
As these countries gain strength, the threat of nationalisation of oil assets increases. The bottom line is that most of the world's oil lies beneath regions that do not have the most cordial relations with the West, and oil is increasingly likely to become a political weapon.
Such nationalistic polices are likely to push up crude prices over the coming years. The effects of such policies are an increase in supply concerns and a drop off in foreign investment and exploration.
A perfect example is the actions of the Russian Government. Hugo Chavez in Venezuela and Evo Morales in Bolivia are also tightening the governmental grip in their respective nations.
The recent rise of China adds another element to the oil mix. With less history of political interference, China has wasted no time in capitalising on its superior foreign relations. In recent times China has secured long term supply deals with Iran, Russia and countries in Latin America and Africa. China's demand for oil, currently around 8 million barrels per day will continue to rise and increasingly compete with the energy demands of the US.
China is encouraging its oil companies to secure energy resources domestically and abroad in order to supply its growing economy. For example, CNOOC Ltd, China's largest offshore oil company, is accelerating the pace of crude oil exploration and production. It spent US$2.7 billion on Nigerian fields last year and is scouring Africa and Asia for reserves.
"In the event of heightened geopolitical tensions, oil importing countries such as China and Japan will pay up for energy security."
OPEC recently agreed to a second round of production cutbacks, involving a 500,000 barrel-a-day supply cut starting February 1. The reduction will come on top of a 1.2 million barrel-a-day cut that kicked in on November 1. These are OPEC's first production cuts since 2004.
The market's response has so far been one of cynicism, believing that OPEC does not have the discipline amongst its member countries to be able to implement a cut of such a magnitude. However the organisation was very proactive in terms of managing supply from 1997 onwards (in the wake of the Asian economic crisis) and had a major role in the enormous leap in crude oil prices from US$10 a barrel.
In summary, we believe investors need to adopt a broad outlook with respect to oil and look past the short-term factors currently driving the price, to the more fundamental issues that will determine the price over the medium to longer-term. We believe the world must become accustomed to higher oil prices.
Growing demand, the rapid rate of field depletion, ongoing political risk issues and OPEC supply restraint, are likely to see continued supply tightness. Consumption in China and India will increase enormously, putting pressure on already stretched supplies. As such, world oil markets must face the harsh reality of higher oil prices for years to come.
Greg Smith is the Managing Director of Fat Prophets. If you would like a further sample of their expert research please click here.
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