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By Stuart Goodwin, Hargreaves Lansdown
After peaking at an unprecedented level of $147 per barrel last year, the oil price crashed below $40 in December 2008 due to faltering demand in the wake of the economic slowdown. It has since rallied as a degree of confidence returns to markets, but the current level of $62 is still well below its peak. In the short term the oil price will be influenced by whether OPEC decides to increase, cut or maintain its overall level of oil production. A cut in production should lead to a price rise, whereas extra production will tend to depress the price. Clearly it is in OPEC's interest for the price to be as high as possible, but they have a delicate balancing act. If they help drive the price too high then global economic growth will be further damaged and this may send the oil price lower again. Recent comments from the Saudi oil minister suggest that production is likely to remain unchanged, and this seems to be the consensus. Even Iran , which traditionally has been the most eager for cuts in production, described the possibility of doing so this time as ‘remote'. However, OPEC has a history of making unexpected decisions, so the outcome of Thursday's meeting will be eagerly awaited. The recent price recovery in oil may not last in the short term. Demand for oil continues to fall at its fastest pace since the early 1980s; the International Energy Agency (IEA) forecasts that demand will fall by 3% this year. What is more, oil stockpiles across the world are at record highs. Low economic growth, large oil reserves and falling demand is a recipe for lower prices in the short term. Taking a long term view, however, the picture is very different. The fundamental reasons for last years' price spike have not gone away. The rapid industrialisation of developing countries is raising the bar for global oil demand. As these nations grow they will require more oil, and when the West emerges from recession our own appetite for oil will increase once again. The current stockpiles won't last long in such an environment. Despite investment in alternative sources of energy such as nuclear and wind, it is hard to see the world breaking its addiction to oil in the foreseeable future. So the long term outlook for demand is positive, but what about supply? The days of “easy oil” have gone. Most of the world's readily accessible supply has already been used up and, while there is plenty more oil under the ground, much of what's left is far harder to reach. New discoveries tend to be smaller than in the past and extracting it will take longer and be more expensive. As costs increase for oil producers the price should rise to compensate. Indeed some projects only become economically viable when the oil price is high, such is the extreme cost of extraction (e.g. the Canadian oil sands). Many years of low oil prices in the 80s and 90s led to significant underinvestment in equipment, technology and manpower. Overall investment in new supply continues to fall, with the IEA estimating a reduction of 15-20% this year. The oil industry is poorly equipped to respond to a sudden increase in demand. This is what led to the more than ten-fold increase in the oil price during much of this decade, and the picture could look little different during the next economic boom. An important point for UK investors to consider is the effect of currency movements. The oil price is quoted in dollars, so if Sterling strengthens against the dollar it will make oil relatively cheaper for a UK investor. Of course the exchange rate can move the other way too, making oil more costly in Sterling compared to US Dollars. One way to make an investment linked to oil is through the shares of companies in the oil industry. These stand to benefit from a rise in the oil price as in that environment their earnings will tend to rise faster than their costs, thus increasing profit. The Junior Oils Trust specialises in investing in the shares of oil companies, especially smaller ones that are well placed to benefit from potential takeovers from the global oil giants. An alternative way to access oil is through a more diversified fund that also invests in other areas of the commodity market. The JPM Natural Resources Fund is one of our favourites. While primarily exposed to mining and metals, it also has significant exposure to the oil industry and is managed by one of the most experienced and best resourced commodity teams around. The outcome of OPEC's latest meeting will be interesting, but regardless of what happens to the oil price in the short term, the long term outlook is positive. Investors must remember that this is a volatile area so should be considered a high risk investment, however bold investors prepared to see their capital fluctuate in value may find a superb long term opportunity in oil. Stuart Goodwin is an analyst at Hargreaves Lansdown Useful links: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
The Organisation of Petroleum Exporting Countries, better known as OPEC, has recently met in Vienna to agree its oil production levels for the next few months. The cartel, which includes many of the world's leading oil producers, exerts a significant influence on the price of oil.
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