Friday, March 4, 2011

Crude Oil Future Outlook

Oil prices have once again grabbed the attention of both investors and consumers alike in recent weeks as prices of the precious liquid reached a 2 year high of USD$93.57 on the 22 February 2011. With the global economy continuing to stage its come-back and growth becoming more entrenched, inflation has returned to many emerging countries as crude oil has spiked in price into USD$90/barrel territory, bringing back fears of oil closing above the psychological barrier of USD$100.

Key Points:
* Global oil demand & supply grew at comparable levels in 2010 with no major imbalance.
* Global demand & supply for 2011 is expected to follow suit, supply should be able to satisfy rising demand on the back of returning economic growth in the developed countries.
* Big oil companies have increased their Reserve Replacement Ratio, option to increase output possible if chosen.
* Refinery utilisation rate remains at a comfortable 82% with 744,000 barrels per day of spare capacity.
* Oil companies to form more links with state-backed Oil entities.
* US dollar expected to strengthen moderately over 2011, potentially removing a possible contributing factor to higher oil prices.
* Commercial Traders net Futures position in deep 'short' territory.
* Managed money net futures position has been aggressively 'long' since August 2010.
* Gain exposure to oil via equities instead of oil futures.

Oil prices have once again grabbed the attention of both investors and consumers alike in recent weeks as prices of the precious liquid reached a 2 year high of USD$93.57 on the 22 February 2011. With the global economy continuing to stage its come-back and growth becoming more entrenched, inflation has returned to many emerging countries as crude oil has spiked in price into USD$90/barrel territory, bringing back fears of oil closing above the psychological barrier of USD$100.

Recent events have conspired with speculative forces to drive up the price of oil. With turmoil in North Africa possessing a worrying contagion effect, civil unrest has been spreading from Tunisia to Egypt in a mere fortnight, with the Middle East now in the cross-sights.

As complex as it is to extract, it is even more difficult to paint a full picture of the multitude of factors affecting the price of oil.

Fundamentally, oil is influenced by the all too familiar mechanics of demand and supply, the value of the US dollar, oil companies and the M&A space within the industry, and last but not least, refinery inventories. Apart from these fundamental factors, prices are heavily shaped by the futures positions where the long-heralded speculative forces come into play. The preceding factors will be the main focus of this article.

The Building Blocks of Demand & Supply
Oil demand over the course of 2010 rose by approximately of 2.3 million barrels per day (mbd) from 2009’s average levels to average 86.6mbd in 2010. Similarly, supply rose by 2mbd to average 86.4 mbd. With no major supply-side shocks, apart from the Deepwater Horizon incident, prices remained within an acceptable band of USD$75 to USD$85.

In 2011, we expect global demand for oil to grow 3% or 2.6mbd to reach 89.24mbd, a demand level roughly equivalent to pre-crisis levels. With the developed nations regaining economic strength, as exemplified by the US which is expected to grow by 3% according to our estimates, such demand levels are not unjustified.

We are estimating supply-growth to be 1.7%, or around half that of demand growth. Such a conservative rate would see supply rise by 2.8mbd to 89.2mbd. With OPEC indicating that it could increase production levels to meet rising demand, industry productivity gains and new field discoveries in Latin America, we remain confident of supply being able to satisfy demand.

Oil Companies, Refineries & Inventories
The oil industry has been doing well in recent times, with the return of slick profits at most big oil companies. Apart from financial health, an important measure of theirs is the Reserve Replacement Ratio (RRR). The RRR, is the percentage of a company’s oil and gas reserves consumed by production during the year that were replaced through either acquisition, improved recovery, or new discoveries.

As at the beginning of 2010, big oil companies were doing well, with RRR’s of 226%, 141% and 131% for the likes of Exxon Mobil, ConocoPhillips and BP respectively. The increase in their reserves bode well for oil supply as it signifies an increase in potential oil supply. This gives them the option to increase supply should it be required and if it is profitable to do so. In addition, Barclays Capital forecasts a rise of 11% in spending on exploration and production by oil & gas companies, further heightening the probabilities of further increases in the RRR in time to come.

The recession caused by the financial crisis witnessed a fall in the number of refineries in operation. The number of refineries currently in operation stands at 137 with 11 idle refineries, a sizeable difference from 2008’s 146 operating with 4 idle. Despite the reduction of refineries in operation, only 2 of the current 11 idle refineries need to be re-activated to match 2008’s production levels as average production per refinery has increased by 4.3%, from 117,895 barrels per day in 2008 to 122,994 in 2010.

Providing supporting evidence to the above, utilisation rates of the refineries currently in operation measured 82% as of October 2010. This provides spare capacity of approximately 744,000 barrels per day, a far cry from 2008’s rate of 89.5% and a mere 146,000 barrels per day of spare capacity during the peak in oil prices in 2008. Thus, an increase in oil supply is possible through the intensification of currently comfortable refinery utilisation rates.

The main reason for the existing comfortable levels of spare capacity despite fewer operating refineries is that the capital investments made by the industry during the peak in oil prices in 2008 are starting to pay off. The investments and upgrades made have allowed the refineries and oil companies to produce more barrels per refinery as well as a broader variety of crude grades to satisfy the regulatory product specifications in the US and Europe.

Mergers & Acquisitions
The announcement of a USD$16 billion share-swap between BP & Rosneft on 17 January 2011 heralds a new era for big oil companies. The deal grants BP access to Russian oil fields, through Rosneft’s drilling licence, where an estimated 75 billion of reserves remain undeveloped, enough to last the world for more than 800 years at current usage rates if nobody else produces anymore oil!

The easing of resource nationalism as demonstrated by Russia in this case could spell the dawn of a new era for big oil companies. With countries such as Russia and Venezuela being oil-reserves rich, but lacking the critical know-how and technology to fully maximise their oil reserves, it is expected that big oil companies will form more links with state-backed oil businesses. The transfer of knowledge and access to proven oil reserves stand to benefit both parties.

Chart 1: Fall Of The Dollar In 2010
Fall Of The Dollar In 2010

Value of the Dollar
As most investors would know, the pricing of commodities in US Dollars (USD) leads to an inverse relationship between the USD and commodities. Broadly speaking, when the value of the USD declines, commodity prices tend to rise to reflect their real value.

The DXY Index is a convenient index to use as a simple method for referencing the strength and weakness of the USD against a basket of currencies. From Chart 1, one can observe the decline of the dollar when the Federal Reserve halted further purchases (it held USD 2.1 trillion) of bank debt, mortgage backed securities and Treasury notes in June 2010. Subsequently, the dollar declined further pending the confirmation of Quantitative Easing II (QE II) which was implemented in November 2010.

Currently, the dollar appears to be oversold given the strength of the US economy, with the Federal Reserve raising their forecasts for US GDP growth to range between 3.0 - 3.6% for 2011. It is important for investors to bear in mind that QE II is poised to expire in a few months, and given the renewed strength of the US economy, there appears to be little downside risk baring some unforeseen event e.g. QE III.

Looking forward, the USD is expected to appreciate modestly over the course of the year according to Bloomberg’s consensus estimates.

The value of the Dollar is thus expected to provide one less bullish factor for prices, and to actually dampen the mood for oil price appreciation. Should oil prices strengthen in hand with the USD, then, the value of the Dollar should not be cited as contributing factor.

Oil Futures & the Dark side of the (Speculative) Force
With plenty of talk about oil futures and the specter that is speculative forces pushing prices up back in 2008, it would be important to revisit this shadowy but important facet of oil prices. The Commodities Futures Trading Commission (CFTC) in the US provides data for monitoring the amount of open-interest in the futures market. The two key elements of interest in respect to oil prices would be the commercial traders’ positions and the managed money (non-commercial) positions.

Chart 2: Commercial Traders Futures Positions
Commercial Traders Futures Positions

The commercial traders are primarily composed of entities who utilize the futures market for business activities. Oil & gas producers, refineries and merchants would thus fall under this category. As can be seen in Chart 2, commercial traders typically hedged their positions against oil prices, with no significant spike in either the long or short positions. As of 15 February 2011, their net position has been a net short of approximately 180,000 contracts, thus, it is apparent that commercial traders are not to be blamed in the futures market, which leaves us staring at the non-commercial traders.

Chart 3: Managed Money Futures Positions
Managed Money Futures Positions

The non-commercial traders (money managers) are defined as those who take positions that are purely speculative. A "money manager," is a registered commodity trading advisor (CTA), a registered commodity pool operator (CPO), or an unregistered fund identified by CFTC. As seen in Chart 3, managed money has been extremely active, with the spread between their long and short positions steadily increasing since August 2010. Contrary to the positions of commercial traders, managed money had a net long position of approximately 202,000 contracts as of 15th February 2011 (Chart 4).

Chart 4: Managed Money Net Position.
Managed Money Net Position

Observing the trend in Chart 5 which, one can see the speculative effect managed noney has had on the price of oil with the sudden positive spike in futures positions from August 2010 mirrored by the price spike from September 2010 till date.

Chart 5: Oil Futures Versus Oil Price
Oil Futures Versus Oil Price

Moving forward, with the CFTC looking to impose new laws limiting the number of contracts a single trader can hold as well as the reporting of all positions (including swaps) to the central repositories and authorities, it remains to be seen if managed money will be able to continue having the same level of influence it currently can exert on oil prices.

All in a Barrel
From the fundamentals mentioned above to other unpredictable elements such as seasonal variables (e.g. winter heating demand), OPEC output decisions and geostrategic tensions, it is near impossible to size each one of them up and their respective impact on oil prices in a precise and definitive manner.

From a fundamental point of view, the measures of demand and supply are evenly balanced. With the unpredictable elements and speculative effect hard to forecast, not much value can be added to investors if forecasting is done based on guesswork. As such, we’d rather investors avoid the direct investment into oil futures which are extremely volatile, with prices able to rise 6.36% in a single day (22 Feb 2011), and fall as much as 7.12% over a 15 day period(31 Jan - 22 Feb 2011) respectively.

We recommend investors gain proxy-exposure to the sector via equities as its the energy companies who are able to influence the supply of not just oil, but other energy products such as natural gas. We prefer the relatively low-risk big oil integrated companies with their robust balance sheets, steady free cash flows and diversified sources of income.

Currently, big oil companies are relatively cheaper than world equities as measured by the MSCI AC World Index as shown in Table 1, this despite a few of them posting exceptional financial results over the past few weeks.

Table 1: Valuations of Big Oil Companies & World Indices.
Valuations of Big Oil Companies & World Indices

Thus, in addition to our preference for equities over commodities for reasons mentioned above, the relatively cheaper valuations of energy companies provide a more compelling opportunity with which to gain exposure to the extremely volatile commodity that is oil.


Source: FundSuperMart
Author : iFAST Research Team

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