Threadneedle: Energy sector outlook
Oil prices have continued their upward trend in 2007, with Brent Crude averaging $69.70 at the time of writing compared to $65.40 in 2006 and $54.45 in 2005.Energy sector commentators have generally been behind the curve in this oil cycle, with forecasts having to be revised higher as the cycle has been prolonged and the price has continued to rise. Although there is a chance that the next few weeks could see a pull back from the current speculative levels, our forecast for 2007 of $70 appears to be about right. But what about next year?
When trying to assess future prices it is logical to start with demand and supply, but the first of these metrics in particular is subject to uncertainty, with the two major sources of demand – the US and emerging markets - going in opposite directions. It is becoming increasingly clear that the US economy will be severely impacted by the sub-prime crisis and attendant downturn in the housing market, with GDP growth in 2008 likely to be 2% at best. Meanwhile, emerging markets continue to expand at a robust pace, generating strong demand for natural resources in the process. Which of these two forces prevails is one of the great imponderables for investors. We believe that the forces will largely cancel each other out, resulting in global growth of around 4% in 2008.
As far as supply is concerned, the situation is somewhat clearer. Conditions are generally tight, with inventories at modest levels and current exploration projects suggesting that new supply will not be sufficient to meet the demand from emerging economies such as China and India. The conclusion from this is that, in the absence of a significant deterioration in global growth, the average price of a barrel of oil is likely to be above $70 in 2008. We may even see spikes above $100 oil in the next year if demand is stronger than expected or we experience real or imagined supply disruptions.
With the oil price apparently well underpinned it is logical to be positive on the energy sector but, within this, the fortunes of the various sub-sectors, and the stocks that they comprise, are likely to be highly divergent. The oil majors of the developed world are hampered by limited access to new resources, together with the increased cost of exploration. On the flipside of this negative view, however, there are two groups of beneficiaries.
The first is the “national champions” of the oil producing countries. These companies typically have large reserves and are granted preferential access to new projects. The scale of these new discoveries, as evidenced by Petrobras’s recent announcement of a reserve thought to contain between 5 and 8 million barrels of oil, can be impressive and can have a big impact of the companies’ earnings profile and, therefore, stock price.
The second group of beneficiaries is the companies supplying the oil majors as they seek new reserves. Areas such as oil services have performed well as they have been able to increase their fees in the face of strong demand, while oil refining companies have seen expanding margins in recent months. So our preferred way of playing the ongoing bull market in oil is via national champions in oil producing nations and oil services and refining stocks elsewhere.
Looking further out, sustained high oil prices and dwindling supply will inevitably bring the spotlight onto alternative energy companies. There are currently very few companies with the scale and pricing power to make money in this area, but further rises in conventional energy prices will increase the competitiveness of alternative players. The companies with the right technology will turn out to be exciting long-term investment opportunities.