FIGURE 1: NARROWING THE UNIVERSE

The oil stocks which trade on the ASX show a strong correlation to the oil price, whether looking at TAPIS in AUD, WTI in USD, or Brent in either currency (see Table 1). As a result, identifying when a break from correlation should occur is critical when timing investment decisions and can contribute significantly to alpha.

TABLE 1: CORRELATION OF OIL PRICES TO ASX OIL AND GAS STOCKS

FORECASTING THE OIL PRICE

Forecasting the oil price requires an examination of demand and supply in the oil market. Other important drivers include the excess production capacity, global inventories, the marginal cost curve, refinery efficiency and utilisation, speculative investment flows, and political risk. Past up cycles have been driven by political risk and spare capacity, but only when GDP was growing and demand was strong (see Figure 2). The trigger on oil price to recover from down cycles has always been positive demand growth based on GDP growth (see Figure 3).

FIGURE 2: OIL PRICE AND KEY CATALYSTS

Equation 1: (%Δ GDP – 2%) = %Δ in global oil demand

FIGURE 3: GLOBAL DEMAND RELATIVE TO GDP

A review of supply/demand balance indicates that the call on OPEC crude will be ~-2.6 mmbbl/d in 2009 including Natural Gas Liquids (NGLs), and OPEC’s April output was ~ -2.9 mmbbl/d compared to 2008. Therefore stocks should begin to decline over the next quarters. This will provide fundamental support to the oil price which is unsupported now at current stock levels (see Figure 4), especially leading in to the US driving season which appears to be strong this year.

FIGURE 4: DAYS OF STOCK COVER VS. OIL PRICE

Days of OECD stock cover still stand at ~61 days, with OPEC indicating a target of 52 days (equivalent to $75 oil price in OPEC estimation). There is an excess 405 mmbbl (Million Barrels) of stock at present demand levels. At a -0.3 mmbbl/d supply deficit, it will take several years to reach this target without demand increasing. However, demand is expected to recover through the next quarters, and the amount of demand recovery will determine how fast the extra stock will be used.

Coming up next month
Cycles and Strategies in Oil Investment – Part 2: Leverage to the Oils Price

The oil price support continues to fascinate me given the current demand and days of stock cover.  I expected this quarter to be a very low demand cover leading into driving season, and it has been.  At the same time, inventories are full , so while governments in the past have used the 2nd quarter to refill reserves, there is no need for them to do so now.  I expected prices to fall, especially given the fact that driving miles are lower than usual for this time of year.  Refiners have been doing a good job of maintaining reasonable utilization rates and therefore gasoline stocks are below the 5 year average, providing support for the price.  But discussions with traders recently seem to suggest that even that isn’t enough to support a >$50 oil price.

Perhaps the speculative argument finally applies.  An expected weakening of the US Dollar is pushing investors into ‘real’ investments – commodities.  And gold is much more expensive than oil currently, so oil is benefitting.  It can only be at times when fundamentals don’t support price that the speculative investment effect becomes obvious, and this could be one of those times.  I will be interested to see what happens over the next few months – especially as we start to see how badly the recession affects the driving miles of the US.  I am betting on the oil price range trading between $40 and $60 – but I have a colleague willing to take me on and say the oil price gets near $100 again over the next few months.
Interesting

I have been invited to give a keynote presentation at the Excellence in Oil & Gas 2009 conference. I will be discussing “Oil and Gas Investment Outlook 2009: Cycles and Strategies”.

The Excellence in Oil & Gas investor congress showcases the Australian oil and gas industry to the investment community who are located here in Australia as well as international investors from the likes of China, India and Singapore.

For the full speaker line up, visit the Excellence in Oil & Gas website

***UPDATE***

See my conference presentation here: Investing in Oil and Gas – Strategies through the Oil Price Cycle