The price of oil

There are too many variables - geological, economic and political - to be able to forecast the future price of oil with a high degree of certainty; however, certain trends in the oil market are becoming irrefutable. Most notably, neither oil supply nor demand has responded to higher prices in recent years to the same extent as during previous periods, and there has been a rapid escalation of the oil price (from $10 per barrel in 1998 to $90 per barrel today).

Investors are asking whether oil prices will 'correct' from prevailing levels, as they have done in the past, or whether the cost of oil will remain high owing to structural changes in the oil market. Newton's oil analysts argue that the environment today has indeed changed, that the (previous) mean-reversion of the oil price is unlikely to take place, and that a shortage of supply and the resilience of demand are likely to cause the oil price to rise further.

In terms of supply, the giant oilfields that have accounted for the bulk of the world's oil production over the last 40 years are becoming exhausted. As these fields are depleted, the rate of decline of existing production increases and the amount of new output required to sustain production growth escalates. Given that volumes of discovered oil peaked in the mid 1960s (see chart), and that new discoveries amount to only 30% of the volume of oil consumed globally every year, it is not surprising that supplying oil is becoming more challenging and that oil companies are continuing to miss growth targets. At Newton, we have a supply model that takes account of all new field developments, rates of decline in existing sources of production, and additions to supply from exploration. This model is starting to show some startling trends.

In terms of demand, oil has become predominantly a transportation fuel since the oil price 'shocks' of the late 1970s. The outsourcing of manufacturing and services to the world's most populous nations has boosted demand for transportation in the developing world in particular and this demand should more than offset the effects of energy conservation and efficiency measures being put in place in the OECD (Organisation for Economic Co-operation and Development) nations. There is little scope to substitute other fuel sources for transportation, with only biofuels providing a realistic alternative; and there are limitations on biofuel volumes given the competing use of suitable crops for food.

Newton's oil analysts have looked at three supply and demand scenarios in order to assess the range of likely outcomes for the oil price. Their work shows that either global demand must adapt rapidly to tighter supply conditions or oil prices will continue to rise, conceivably to over $200 per barrel by 2012. The difference between an under-supplied market and an over-supplied market is small, however, and immediate action to reduce demand and minimise the impact of reserve depletion could cause the oil price to fall to about $70 per barrel; but this would only be the case if oil and service companies, consumers and governments were to focus immediately on increasing supply and reducing demand.

The most likely outcome lies somewhere between these two scenarios, with some price escalation occurring against a backdrop of slowing global economic activity. This 'base case' envisages there being little or no spare production capacity during the next few years, a rationing of demand by price, and peak global oil production occurring by the end of the decade, which would entail the gradual rising of oil prices to, perhaps, $135 per barrel by 2012.

The modelling of these scenarios demonstrates that the point of 'peak oil' production is close. The concept of peak oil is straightforward: it takes millions of years to generate oil but, given the finite nature of the resource, it will take just decades to use it. At some point, the rate at which oil can be produced will be limited by the scale of remaining reserves, and that point is referred to as 'peak oil'.

As the gap between the amount of oil that is discovered and the amount that is consumed has been growing for 25 years (with the equivalent of only 30% of annual global consumption being discovered), the point of maximum global production has been drawing nearer. Newton's oil analysts believe from their observations of supply trends that peak production is likely to occur before the end of the decade, and that it may even be happening already. Indeed, they estimate that oil production in 55 of the 63 major oil-producing countries has already passed its peak.

Geologists believe that peak oil production will occur when roughly half of potential production has been realised. Our analysis suggests that, with 1.1 trillion barrels of oil produced to date, the total volume of recoverable oil (including that already produced) lies at the lower end of the wide range of published estimates (of two to five trillion barrels).

Many of the OPEC countries appear to have been over-ambitious with their reserve estimates, probably in an effort to ensure that individual production quotas were met. The relevance of such quotas appears now to be reduced and our oil analysts question the perceived wisdom that OPEC has spare production capacity. They believe that only Saudi Arabia may have such capacity and that this is likely to comprise less valuable (heavy and sour) crude.

While there is a strong probability that the oil price will fall from the current level (which is elevated partially because of the safe-haven status transferred to oil from a fragile US dollar), we believe that we have yet to see peak oil prices and that any downward 'correction' is likely to be temporary. Unless demand is decimated by a global recession, the oil market is likely to continue to tighten and the consensus price used to value oil companies is likely to continue to rise. Furthermore, concerns over security of future supply (and the associated enlargement of strategic petroleum reserves) are likely to serve effectively to put a 'floor' beneath the oil price of about $70 per barrel.

In summary, we have seen a structural change in the supply side of an oil market that is reaching the peak production of a finite resource. Supply side constraints, coupled to resilient demand, give rise to a high likelihood that the oil price will continue to rise in the medium term.

Portfolio implications: Significant exposure to attractively-valued oil companies is recommended, with an emphasis in particular on companies with long reserve lives, high quality fields and strong production growth.