Oil Market Outlook

The three factors that drive today's oil price - namely rising political tensions, strong levels of demand and tight supplies - continue to work in trinity, exacerbating the fear of a supply shortage. The prolonged nature of these factors helped push the spot price of West Texas Intermediate (WTI) crude, a key benchmark, to a new record high of US$77 per barrel earlier this month.

In terms of political unrest, the recent escalation of hostilities in the Middle East has highlighted the extent of tensions throughout the region. Elsewhere, Nigeria, Africa's largest supplier of crude, continues to suffer from destabilising uprisings in key oil producing areas ahead of the country's elections next year. Potentially more disturbing, however, is the growth of "resource nationalism". State-owned or controlled national oil companies already account for around 90% of the world's oil and gas reserves and are becoming increasingly confident in their ability to manage the future on their own terms. The re-emergence of populist politics across South America as is evident in Ecuador, Venezuela, Argentina and Bolivia, demonstrates just how fast the playing field is changing. Meanwhile, the tightening of controls on Western companies across Russia, Qatar, the United Arab Emirates (UAE) and Algeria, underlines how quickly the energy agenda is being wrestled away from the end-users.

The second consideration, the demand picture, looks hardly to have changed. The energy requirements of emerging economic giants such as China or India have been a key driver of oil demand in recent years and, despite the rising prices this has generated, there seems little sign that such demand will lessen any time soon. Indeed, China has just reported GDP growth of 11.3% for the second quarter of this year, its fastest rate of growth for 10 years. But while all eyes have been turned towards Asia, many analysts have failed to sufficiently account for the growth in energy demand from the increasingly affluent oil producing nations - anyone who has visited the indoor ski resort in Dubai will immediately appreciate this!

Not surprisingly, the third element, supply, continues to struggle to keep pace with demand. Nigeria is just one example of where output is failing to stay on course, while on drilling projects around the globe we are now seeing consistent evidence of delays resulting from shortages of everything from technology and machinery to experienced operators. The original giant oil fields, upon which we have relied for so long, are now running into terminal decline. This is the case at the Cantarell Field in Mexico, the largest field outside of Saudi Arabia, which is perched on the doorstep of the world's greatest oil consumer and importer.

With this in mind, there seems plenty of support for oil at US$70 per barrel for some time to come. Only weaker than expected demand figures from the annual U.S. driving season are likely to have any significant impact on this scenario in the short term, and analysts will be closely scrutinising this data over the next few weeks. Similarly, oil analysts are on hurricane watch, as any significant disruption in the Gulf of Mexico will further tighten the supply picture.

With the oil price likely to remain strong, we continue to overweight the oil sector in our global portfolios. In terms of oil stock selection for 2006, we have been heavily backing the integrated oils. These had underperformed during the initial race for oil price leverage, but now offer the combination of oil price and refining leverage - especially as the tautness in global refining capacity has been accentuated by changing specifications for oil products, particularly in the U.S. As we look forward, the key themes to which we are looking to build exposure are 1) global natural gas (which remains out of favour following the recent collapse of U.S. prices); 2) oil company spending; and 3) the consolidation we expect to see across the sector. The market remains rightly concerned that higher prices will impact demand but at this stage, any oil price corrections are likely to result in buying opportunities. This is because extensive discrepancies remain between company valuations and the forward oil price, the price of U.S. crude and U.S. natural gas, as well as between asset valuations and company valuations. Until these discrepancies are corrected oil, and particularly gas, stocks will remain attractive.