Friday, March 4, 2011

Turmoil In MENA Causing Spike In Oil's Price, Hampering Equity Markets' Performance

With turmoil in the Middle East and Africa (MENA) worsening over the past few weeks, oil prices have grabbed the opportunity by the horns to leap over 13% since February 15 as worries of supply disruptions having subsided from Egypt's rage, renewed themselves with vigour as Libya (a member of OPEC) continues to be consumed by civil strife.

Key Points:
* Turmoil in MENA causing spike in oil's price, hampering equity markets' performance.
* Saudi Arabia implements massive social measures in a bid to prevent similar social unrest and uprisings.
* Libya constitutes only 5.4% of OPEC's production, approximately 1.6% of global oil production.
* OPEC's spare capacity stands at 5.6 million barrels per day, more than sufficient to cover any shortcomings in Libyan output.
* WTI-BRENT spread should narrow upon easing of MENA tensions.
* Gain exposure to oil via equities instead of oil futures.

With turmoil in the Middle East and Africa (MENA) worsening over the past few weeks, oil prices have grabbed the opportunity by the horns to leap over 13% since February 15 as worries of supply disruptions having subsided from Egypt’s rage, renewed themselves with vigour as Libya (a member of OPEC) continues to be consumed by civil strife. The general stock market performance from the 15th of February 2011 has been depressed as seen in Chart 1 as negative investor sentiment grew as a result of the turmoil.

Chart 1: Market performance
Market Performance

Middle East & Africa
The turmoil in the MENA appears to have little hope for respite. Following the dethroning of Egypt’s Hosni Mubarak, another long-term head of state, Libya’s Gaddafi is in serious danger of following suit. Complicating the already fragile situation, what initially started out as demonstrations has morphed into a chaotic conflict in the country, with pilots defying orders to bomb civilians and troops defecting to the opposition. To top off the growing list of problems for Gaddafi, the oil rich Eastern region of Libya is now in the hands of the opposition. Worryingly for the West and the Middle East, the tensions show no sign of abating. With Saudi Arabia purportedly being the next in line for demonstrations, the government has acted swiftly to placate the common man. The Kingdom has budgeted $10.7 billion for social spending to improve housing, with other funds made available for education and other social welfare programs. In addition, the King has promised financial assistance for up to 1 year for Saudis who are unemployed. We believe the above should prove sufficient to appease the general population at large.

Paying Lip Service to Libya
With all the talk about tensions in the MENA region, let’s take an objective and quantitative look at the potential impact of losing all of Libya’s supply. Libya, although the largest holder of oil reserves in Northern Africa at 41.5 billion barrels, accounts for little less than 5.4 % of OPEC’s production. Even if Libya’s oil production capabilities were severely hampered to the effect of literally zero output, OPEC’s spare production capacity is actually more than sufficient to make-up for the short fall. OPEC’s spare capacity is the additional amount of oil it could produce with a 30 day notice, for a period of 90 days. As of 31st January, the spare capacity measured approximately 5.65 million barrels per day (Chart 2), a figure roughly 3.6x that of Libya’s daily production!

Chart 2: Opec spare capacity
OPEC Spare Capacity

Spread between the Brent & WTI
There are two main oil markets in the world, the Brent and WTI (West Texas Intermediate). While both oil markets generally move in sync, there is now a significant spread between the prices of Brent and WTI crude as seen in Chart 3.

Chart 3: WTI - Brent spread
WTI - Brent Spread

One of the reasons for the divergence of late is that Brent depends more heavily on crude oil from the Middle East than the North American market which typically gets most of its produced from the Americas. In addition to the above, with inventory levels at Oklahoma remaining at high levels, WTI’s prices have been relatively stifled as a result of the buffer space afforded by the said high inventory levels.

WTI is a lighter and sweeter crude grade of Oil as compared to Brent, which is typically sourer and thicker. Thus, WTI requires less processing and refining for conversion into final products such as Gasoline and the various types of fuel (e.g. Aviation fuel, Jet Kerosene, Domestic Heating Fuel etc), resulting in a traditional premium for the crude from Texas. When the tension in the Middle East subsides, we believe that the spread between the 2 markets will begin to narrow.

How to ride the Turbulence
As mentioned in our article dissecting oil, we’d prefer investors to gain exposure to energy companies as opposed to direct investments in oil futures. If one takes a look into the not too distant future, past the mess that is the MENA region now, when the turbulence eventually subsides and production goes back up to normal levels, bringing down the price of oil futures to the pre-tension levels.

What will happen to investors who had direct investments in oil futures? Looking at the WTI futures, it is clear to see that the regional tension is expected to subside within the next year at worst; bringing oil prices back down below the $100 mark (Chart 4).

Chart 4: WTI Futures
WTI Futures

In addition, with energy companies’ equity performing strongly even prior to the crisis, we remain firm in our preference of energy companies' equities over oil futures. The recent spike in oil prices have done no harm to the fortunes of oil companies yet. As seen in Chart 5, the equities of oil companies have been performing well over the past 2 months following robust profits and estimates, with the tensions in the Middle East simply helping to aid the already impressive performance.

Chart 5: S&P500 Integrated oil & Gas Index
S&P 500 Integrated Oil & Gas Index

While investors could worry about Energy companies being forced to stop production in the affected countries in the Middle East, the truth of the matter is that the increase in oil prices should be more than able to offset the losses from the drop in production.

Moving forward, we do not expect regional tensions to heavily impact the Middle East and in particular Saudi Arabia, the world’s largest exporter of oil. We would not be surprised if other Middle Eastern countries roll out more social measures in an attempt to prevent social unrest and appease the masses. We recommend investors to remain calm and wait for the storm to past as market fundamentals have not changed.

Investors looking to participate in the energy sector should read our previous article, Crude Oil Outlook, to get a more detailed picture of oil.

Source: FundSuperMart
Author : iFAST Research Team

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