Oil: Too Fast, Too Furious—Now Time for a Break

Source:

The risk/return profile is currently not attractive for oil investments. Investors will have to give up their belief in perennially rising prices (for now). . .

The risk/return profile is currently not attractive for oil investments. Investors will have to give up their belief in perennially rising prices (for now). OPEC has signaled more than once that it regarded a price band of USD 70–80 as optimal, and we do not expect the cartel to abandon that view. The slump from USD 150 to USD 30 was excessive, but the current prices do not reflect the low demand in our opinion. From our point of view, the drastically increased risk appetite, excess liquidity, and optimistic expectations of a significant economic recovery were the main contributors to the price rise. And the unshakable trust in the alleged Chinese economic miracle is fuelling hopes for a further price increase. Therefore we think that any further price increase will ultimately be built on shaky grounds and will thus not be sustainable. However, the economy is probably still in for a bumpy ride. We still doubt the hardiness of the “green shoots” and think that there is too much economic optimism priced into the oil sector. We can hardly see any room for positive surprises; as soon as the global stimulus programs expire (and do not get replaced), oil demand should recede again. The artificially created prosperity should not be confused with actual, healthy growth. Therefore the discussion should be shifted to the latently weak demand.

The low oil demand is best reflected by the weak crack spreads and the low capacity utilization of the refineries. The high inventories probably represent the Achilles heel of the oil price, as the current oversupply will exert pressure on the price. As soon as demand is primarily covered from inventories, the downward momentum should pick up speed again.

Currently there is enough oil around, but the structure of the supply would suggest considerably higher prices in the long run. Given that oil was sometimes traded below the marginal costs of production last year, which caused numerous oil nations severe financial hardships, investments worth almost USD 100bn were scrapped. This could be the base for a fourth oil shock 2012 or 2013; this year we only see little upward potential left.

We think that geopolitical problems and military conflicts are currently not taken sufficiently into account and represent a massive risk. In Nigeria, the number of attacks on pipelines has drastically increased. Given that President Yar A'duas's health is still critical the situation should remain unstable. The Iran conflict seems to be coming to a head as well. In case of a military square-off, the Strait of Hormuz, i.e. the most important trading route for oil from the Gulf region, would be blocked. And the parliamentary election in Iraq in March as well as the withdrawal of troops of the U.S. military in August should cause tensions too.

We are clearly bullish on natural gas in the long run, especially on unconventional natural gas resources. For the next three to five years we expect prices within a band of at least USD 7 to 10. This should ensure attractive margins for alternative natural gas producers. According to an old rule of thumb, the oil price divided by 6 should yield the gas price. This is based on the fact that one requires 6 times as much gas to generate the energy of one unit of oil. This means that currently oil is too expensive, or gas too cheap—or both.

Natural gas should also play a more important role in terms of ecological aspects in the future, given that it burns much cleaner than coal or crude oil. This should also mean additional support for shale gas with respect to the CO2 limits. The only frequently heard points of criticism are the high water consumption and the pipelines that would have to be built; however, the ecological damage is minor when compared to conventional energy sources. Especially in comparison with unconventional oil (e.g., oil sand), shale gas is ecologically clean and energy-efficient to boot. We are therefore optimistic that the exploration of shale gas reserves will become massively more important in Europe. We expect particularly keen exploration and acquisition activities in Poland and the Ukraine.

For this reason we regard unconventional gas—especially shale gas—as one of the most interesting investment opportunities in the energy sector.

We interpret the fact that the oil price is currently still on the rise in spite of the seasonal weakness and the rejuvenated U.S. dollar as clear signs of strength. The sentiment is currently neutral as well and far away from any buying stampede or euphoria, as is supported by the COT data. According to the ratio analysis oil is currently valued within the boundaries of its long-term history relative to other asset classes. Seeing that there is an oversupply of oil, we do not expect the oil price to trade above the "magic" mark of USD 100/barrel on a sustainable basis. The market seems to be in good balance for 2010. Only a broad, sustainable, and—especially—global economic upswing could trigger supply shortages. Therefore we expect—for technical and tactical reasons—a continuation of the recent uptrend in the first half of 2010. Due to the negative divergences, poor seasonal factors and the weak fundamentals, we expect a trend reversal for the second half of the year at the latest, where the oil price should dip to the USD 60 area or even lower. Therefore we forecast an average price of USD 72/barrel in 2010. The risk/return profile is currently not attractive for oil investments. Investors will have to give up their belief in perennially rising prices (for now). OPEC has signaled more than once that it regarded a price band of USD 70–80 as optimal, and we do not expect the cartel to abandon that view. The slump from USD 150 to USD 30 was excessive, but the current prices do not reflect the low demand in our opinion. From our point of view, the drastically increased risk appetite, excess liquidity, and optimistic expectations of a significant economic recovery were the main contributors to the price rise. And the unshakable trust in the alleged Chinese economic miracle is fuelling hopes for a further price increase. Therefore we think that any further price increase will ultimately be built on shaky grounds and will thus not be sustainable. However, the economy is probably still in for a bumpy ride. We still doubt the hardiness of the “green shoots” and think that there is too much economic optimism priced into the oil sector. We can hardly see any room for positive surprises; as soon as the global stimulus programs expire (and do not get replaced), oil demand should recede again. The artificially created prosperity should not be confused with actual, healthy growth. Therefore the discussion should be shifted to the latently weak demand.

The low oil demand is best reflected by the weak crack spreads and the low capacity utilization of the refineries. The high inventories probably represent the Achilles heel of the oil price, as the current oversupply will exert pressure on the price. As soon as demand is primarily covered from inventories, the downward momentum should pick up speed again.

Currently there is enough oil around, but the structure of the supply would suggest considerably higher prices in the long run. Given that oil was sometimes traded below the marginal costs of production last year, which caused numerous oil nations severe financial hardships, investments worth almost USD 100bn were scrapped. This could be the base for a fourth oil shock 2012 or 2013; this year we only see little upward potential left.

We think that geopolitical problems and military conflicts are currently not taken sufficiently into account and represent a massive risk. In Nigeria, the number of attacks on pipelines has drastically increased. Given that President Yar A'duas's health is still critical the situation should remain unstable. The Iran conflict seems to be coming to a head as well. In case of a military square-off, the Strait of Hormuz, i.e. the most important trading route for oil from the Gulf region, would be blocked. And the parliamentary election in Iraq in March as well as the withdrawal of troops of the U.S. military in August should cause tensions too.

We are clearly bullish on natural gas in the long run, especially on unconventional natural gas resources. For the next three to five years we expect prices within a band of at least USD 7 to 10. This should ensure attractive margins for alternative natural gas producers. According to an old rule of thumb, the oil price divided by 6 should yield the gas price. This is based on the fact that one requires 6 times as much gas to generate the energy of one unit of oil. This means that currently oil is too expensive, or gas too cheap—or both.

Natural gas should also play a more important role in terms of ecological aspects in the future, given that it burns much cleaner than coal or crude oil. This should also mean additional support for shale gas with respect to the CO2 limits. The only frequently heard points of criticism are the high water consumption and the pipelines that would have to be built; however, the ecological damage is minor when compared to conventional energy sources. Especially in comparison with unconventional oil (e.g., oil sand), shale gas is ecologically clean and energy-efficient to boot. We are therefore optimistic that the exploration of shale gas reserves will become massively more important in Europe. We expect particularly keen exploration and acquisition activities in Poland and the Ukraine.

For this reason we regard unconventional gas—especially shale gas—as one of the most interesting investment opportunities in the energy sector.

We interpret the fact that the oil price is currently still on the rise in spite of the seasonal weakness and the rejuvenated U.S. dollar as clear signs of strength. The sentiment is currently neutral as well and far away from any buying stampede or euphoria, as is supported by the COT data. According to the ratio analysis oil is currently valued within the boundaries of its long-term history relative to other asset classes. Seeing that there is an oversupply of oil, we do not expect the oil price to trade above the "magic" mark of USD 100/barrel on a sustainable basis. The market seems to be in good balance for 2010. Only a broad, sustainable, and—especially—global economic upswing could trigger supply shortages. Therefore we expect—for technical and tactical reasons—a continuation of the recent uptrend in the first half of 2010. Due to the negative divergences, poor seasonal factors and the weak fundamentals, we expect a trend reversal for the second half of the year at the latest, where the oil price should dip to the USD 60 area or even lower. Therefore we forecast an average price of USD 72/barrel in 2010. Download full report.

Related Articles

Get Our Streetwise Reports Newsletter Free

A valid email address is required to subscribe