Cheaper than gas at the pumps

Our principal specialist energy fund advisers wrote at the end of December:

The OPEC meeting was held on 17 December and, much to the surprise of the market, they cut output by around 2mmb/d, which if anything, illustrated how over-supplied OPEC believes the market will be over the next few months. The key question remains: exactly how compliant will OPEC members be over the next few months? We estimate that if the OPEC cuts are adhered to, the market could swing to a deficit in 2009, which could result in a drawdown of crude stockpiles as early as the second quarter of 2009. As detailed in last month’s investment commentary, we continue to focus Fund holdings on those companies that have:
a) Strong balance sheets
b) Strong free-cash-flow generation
c) Strong organic growth profiles, backed by proven and probable reserves
d) Strong company management, who have gone through previous down-cycles
e) Attractive base-case valuations. During the month, we increased the Fund’s weighting in Quicksilver Resources, Petrobras and Ultra Petroleum. All three companies have extremely long life resource bases and are all characterised by being low cost producers within their industry.

We believe that the supply and demand environment for crude oil will remain loose in the first few months of 2009 and then tighten as the year progresses. As investment levels decrease, non-OPEC oil production will decline sharply, while OPEC will deliver partially on their production cuts. We also think that demand will be lower than in 2008, although US and European oil product demand is likely to improve as the year progresses, due to lower prices. Non-OECD demand remains a key variable/risk, although at present we still expect the non-OECD as a whole to see increased demand in 2009.

As a result, we expect Brent crude to strengthen as the year progresses and to average around $60/bl in 2009, although we expect to see high volatility around this price. Beyond 2009, we expect the global oil supply and demand balance to tighten leading to higher prices as demand steadily improves in line with a pick-up in economic activity. The US natural gas market is likely to see a similar pricing trend although the path of the recovery could be more volatile given that drilling activity still needs to be curtailed. We feel that global upstream investment will decrease by around 10-15% in 2009 as a result of lower crude and gas prices. Whilst ‘international’ capital expenditure may see only a modest decline in 2009, US gas market related capital expenditure is likely to fall by at least 25%. Energy equities still offer attractive investment characteristics, even on our $60/bl oil price forecast. It is cheaper to buy oil and gas on the stock market than it is to explore for it organically. We believe that the global oil majors are discounting around a $60/bl oil price outlook long term, which given the cost profile, we see as too conservative.