There have been some interesting developments occurring in the resources sector recently. Despite fears about US economic growth and whether the country has entered recession, many commodity prices continue to make all-time highs. Two in particular, gold and oil, have been gaining most of the headlines.
At Fat Prophets, we have been deeply invested in both of these commodities for years and maintain our position that each are still firmly in the midst of a long term bull market. Today we take a closer look at the oil sector and some of the reasons behind that market’s current strength.
At the start of the year, our target for oil was $110 per barrel with a run to $120 seen as possible. Less than three months later and the first of these targets has already been achieved. Whilst the next few months are typically a period of slower demand and lower prices, we still believe that oil will be well supported throughout the year. Yet oil’s biggest market, the US, is experiencing real difficulty.
There is little question now that economic growth in America has slowed significantly. In fact, there is a strong argument to be made in our opinion that a recession is underway. The latest evidence being disappointing employment figures showing a rise in those out of work. Add in the continuing deterioration in the housing market and credit meltdown and the outlook is somewhat less than inspiring.
Yet the policy response to these problems has underpinned an acceleration in the price of oil. Interest rate cuts by the Federal Reserve have been rightly in our view interpreted as inflationary and detrimental to the strength of the US dollar. With more weakness on the horizon, the Fed in our opinion will continue stoking inflation and undermining the greenback with further cuts.
Internationally, the Bank of England is also lowering rates though in a much more measured pace. And despite representations to the contrary, displeasure with the strength of the euro should mean that the ECB is not far behind in cutting official rates too.
What this all means is that fiat (i.e. paper) currencies will be the ultimate loser. In an era of floating currencies, inflation generally wins out. (When currencies were fixed to gold deflation usually carried the day.) In the end, these policies will ultimately continue to be beneficial for oil prices in 2008.
Meanwhile, the primary engines of growing demand for crude are the Asian powerhouses of China and India. Both of these countries continue to grow at exceptionally strong rates and we do not see any substantial drop off as a result of a US slow down.
For instance, much of China’s growth comes from investment and with the country in the midst of an historic industrialisation phase, we would expect these elevated levels of investment and therefore economic growth to continue.
Tangible evidence of the country’s resilience to slowing export markets is provided by an examination of the impact 2001’s technology led slump had on China’s GDP. From the peak of 2000, China’s export growth rate fell by a hefty 35 percent. Nevertheless, the impact to GDP was a slowdown in growth of less than 1 percentage point.
This is due to the fact that China’s business investment and domestic demand is the major component of GDP growth. Indeed, estimates suggest that even if net exports were removed entirely, the country would still achieve high single digit growth.
And recent retail sales data from China showing a 20 percent increase in January and February is encouraging. We believe this supports the case that domestically led consumption, complemented by infrastructure investment, should help sustain economic growth even if export demand weakens.
This in turn will underpin fast growing demand for energy to fuel the economic growth. Oil is playing a major part in satisfying this demand, which we believe will continue for years to come.
The fundamental outlook for oil is also robust in our view as supply in the years ahead will have to run hard to stay in touch with demand. This is borne out by the International Energy Agency (IEA) who believe a drop in demand in developed countries will be largely offset by increases in emerging markets.
Estimates from the IEA are for demand in 2008 to be 87.5 million barrels per day (mb/d) or 2 percent higher than last year. Total world production last month was also 87.5 mb/d, demonstrating the tight match between supply and demand.
And raising output to provide a buffer and alleviate upward pressure on prices is, in the current environment, a difficult task. Most large and easy to exploit fields have been discovered. This leaves the oil companies in a position where unconventional (oil sands) and expensive (deepwater drilling) resources are the new targets.
This situation creates a floor for oil prices as development will not occur if a weaker oil price makes resources uneconomic. It also means that new discoveries take longer to bring into production. So, although vast amounts of money are being invested, supply simply cannot respond as quickly as demand is rising.
Furthermore, the geo-political risk premium will likely continue to support higher oil prices in the year ahead. From disruption in the Niger Delta, to the rise of resource nationalism and unrest in the Middle East, we believe the location of the world’s energy reserves fully justifies such premiums.
Taken together we believe these are all compelling reasons to remain bullish on oil as we enter 2008. Whilst the strong gains made so far this year opens the door to a correction in the coming months, such pull backs will in our view be temporary as oil continues its i
