Alec Hogg: Three reasons crude oil isn’t soon going back to $100

Photo credit: arbyreed / Foter / CC BY-NC-SA
Photo credit: arbyreed / Foter / CC BY-NC-SA

By Alec Hogg

The halving of crude oil’s price hammered the performance records of many a value investor. Even before oil began its descent, energy-related stocks appeared cheap, making them popular among those addicted to buying cheap. Now value guys who still retain the courage of their convictions are piling in at what they regard as once-in-a-generation prices.

Are they on the right horse this time around? I’m not so sure.

It’s always dangerous to make a “this time it’s different” call, but with the crude oil price there are some good reasons to consider it may now be true.  Underlying fundamentals of the energy market have changed. A powerful new factor has arrived – shale oil and gas.

Energy entrepreneurs have spent millions trying to find a commercially viable way to liberate the oil and gas trapped deep below the surface in the porous shale deposits. But only around a decade back did they crack the code, introducing hydraulic fracturing (fracking) which gave birth to an industry that has transformed the US’s energy equation.

OPEC, the crude oil producers’ cartel, initially ignored the Frackers. But as the shale-derived supplies grew, so did the energy establishment’s concerns. At last year’s annual production quota meeting in Vienna, outsiders expected OPEC to tighten up members’ quotas. Instead, it declared war.

The Frackers’ cost of production is considerably higher than most crude producers. So led by Saudi Arabia, OPEC members were encouraged to hold production, even increase it. The strategy being that additional supply would would drive down energy prices and, in time, put the Frackers out of business.

So far, OPEC has been half right. The oil price has dropped by even more than expected and Frackers cut their sea of exploration rigs back to a trickle. But few shale wells already in production have been capped. Many Frackers have offset the price erosion by drawing on $20bn worth of insurance taken out by the sector to protect against a lower price. For the moment, supply is rampant.

What happens next, though, is the subject of some big bets.

Standard Bank’s West Texas Intermediate (WTI) exchange traded note has experienced sharply increased trade in recent weeks. WTI is far more transparent and a lot more liquid than the traditionally quoted Brent Crude measure. That together with its easy-to-trade quality makes the locally-listed ETN the efficient vehicle for those wanting to put money behind their view on crude.

But should we follow them in?

For me, the outlook if far too volatile to take a plunge. While value investors draw on historical prices to support a view that crude will return to $100 a barrel, I’m not so sure.

Here’s three reasons for scepticism:

  • Exploitable shale is not restricted to the USA. There are bigger, potentially even more exploitative shale oil and gas deposits elsewhere in the world. Argentina is poised to become the second country to join the US Fracking boom. South Africa’s Karoo deposit also holds great potential. Now that human ingenuity has unlocked how to turn shale deposits to account, logic suggests the US is only the first of many.
  • Global polecat Iran is inching its way back to respectability – and aiming to end sanctions that have cut its crude oil exports to a fraction of the past. Iran’s promised rehabilitation would also open the doors to exploration of its vast potential reserves – and in time effectively bring another supplier the size of Saudi Arabia into the market. A normalised geopolitical environment would add Iraq and Libya, both of which are currently delivering a fraction of their potential. Libya, for instance, is delivering 200 000 barrels of crude a day compared with the 1.6m pre-Gaddafi.
  • The previously high oil price has also had a significant impact on demand. Consumers worldwide have switched to cheaper alternatives or become more efficient in their usage – China’s sweeping adjustments the most obvious example. The cure for a high oil price has always been a high oil price. We’re only starting to see the consequences of the last few years of plus-$100 a barrel start to work through.

So how do you play it from here?

My advice is stay on the sidelines. The crude oil price is too tough to call. Let braver souls pile into Sasol or go long of the ETN. The risk remains to high for the potential reward.

Despite halving in the past year, the crude remains vulnerable to further downside shocks. News of a new shale geography; return to the market of a crude supplier; or a breakthrough in renewable energy have the potential to disrupt. There are enough smart people arguing WTI will only bottom around $40 – that’s 20% down from its current level.

Biznews Global Share Portfolio update:

Novo Nordisk, which accounts for 8% of the portfolio, had a double dose of good news for us this week. The share price gained 10% on the news.

After rejecting the application to register Novo’s key insulin drug Tresiba, the US this week gave it the green light. Tresiba is already available outside of US, but two years ago that country’s Food & Drug Administration raised concerns the drug could be linked to a higher rate of heart attacks and strokes. Novo’s trial that focuses on these concerns has delivered sufficient evidence to satisfy the FDA which this week approved resubmitted applications. This clears the way for Tresiba to be sold into the US market next year, a potential $2.2bn a year sales boost.

Novo’s anti-obesity drug Saxenda has been approved to be sold in Europe. This rounds out the most important markets after approval was granted in the US in December and Canada in February – first of its kind approved by Ottawa in over 20 years. Saxenda has not yet been launched. The universal approval of Saxenda is in stark contrast to the experience of competitors.

 

 

 

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