The inflation adjusted (real) oil price is starting to ease back off historical highs
The inflation adjusted (real) oil price is starting to ease back off historical highs

Cure for high oil price is a high oil price. Where next?

Not long ago analysts fretted how the world would cope with an oil price over $200 a barrel. Now they wonder how low alternatives might push the oil price.
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I love the saying that the best cure for a high oil price is a high oil price. Mankind's ingenuity ensures that the world always finds surprising ways to adjust to seemingly intractable economic challenges. Not long ago analysts were fretting about "peak oil" – and how the world would be able to cope with an oil price of over $200 a barrel. Innovations in exploitation of shale gas, solar and wind energy has seen off that threat. So where to for oil now? Sanlam's Olof Bergh reminds us that although the oil price has dropped sharply in the past few months, it remains at historically high levels in real terms. And oil's inability to rise on geopolitical tensions tells a story of its own. – AH 

ALEC HOGG: Geopolitical risks that include ISIS, Gaza, Ukraine, and Syria dominate our headlines. What impact are these events having on global markets and where can you find value in this turbulent world we inhabit today? Joining us now from Cape Town to answer these questions is Olof Bergh. Olof, I guess if the Middle East didn't have so much oil, there would be so much attention paid to what's going on there. I guess, just adding onto that, the problem is that the Americans are becoming less and less reliant on oil imports, are paying a little less attention and we've seen the oil price come down. The whole equation could change.

OLOF BERGH: Yes Alec, that's correct. Firstly, just from the Middle East: it is in terms of global GDP – not a big contributor to the overall picture. The 17 countries, including big countries like Turkey, Egypt, the UAE, and even Qatar overall contributes about five percent of the overall world's GDP. As a GDP contributor, economic upheaval, or disruption in that particular geography, shouldn't really affect or disrupt the global GDP growth perspective. It is a big exporter of oil. OPEC, as a whole, exports between 30 percent and 40 percent of the world's oil and most of OPEC's oil comes from the Middle East, so it is incredibly important from an oil export perspective. In the past, oil itself has had big impacts on global economies and global market. Whenever there's geopolitical disruptions, risk, or upheavals in the Middle East, it often has a knock-on effect on the oil price and subsequently, on economies and the consequence of that is often, weaker markets because of the link between economic growth and long-term market performance.

ALEC HOGG: One wonders what the oil price would be today if you didn't have all of that turbulence going on in the Middle East, given the way the price has fallen over the last couple of months.

This chart of the price of Brent Crude going back 35 years shows that the inflation adjusted (real) oil price is still at historically elevated levels.
This chart of the price of Brent Crude going back 35 years shows that the inflation adjusted (real) oil price is still at historically elevated levels.

OLOF BERGH: Sure. Isn't it remarkable that even with the economic upheaval (or what they call the geopolitical tension) in the Middle East with ISIS being particularly prevalent and disruptive in Syria and Iraq, that the oil price has actually come down from the lower hundreds to current levels of below 90?   That certainly has surprised us. We've been busy with a client presentation where the theme was the geopolitical risk in the Middle East and the effect thereof on the global oil price, and our key takeaway was that we thought the geopolitical risks weren't a major concern and that they wouldn't result in oil price spikes as we've historically seen. Again, our thesis there was that it always is dependent on supply and demand. The supply and demand game has change somewhat in that America has become a lot more energy-independent through the shale gas revolution. In so doing, the supply of alternatives has increased. What has brought on this revolution in international energy markets? There, our primary thinking is that the oil price is very high. It's been high for some time and that's been encouraging – the development of alternatives – as we're seeing in the Middle East and Europe, with alternative energies increasingly coming to the fore and contributing to the overall picture, more than it has ever done in the past. We've been surprised with the decrease.

ALEC HOGG: You have to start worrying about the future oil price in an African context. We'll get there in a moment, but America's not the only people who have shale. In South Africa, we have about half of what the Americans have and we're only number eight in the world. There are other shale gas deposits everywhere else, including very big ones in China. Africa's sitting on 60 percent of its exports being generated by the exports of oil, is very vulnerable in this respect.

OLOF BERGH: Alec, broadly speaking, I think you're right. Africa is reliant on oil exports. South Africa is independent geography. Outside of Africa is much less reliant on oil exports. We would be greatly benefitted by a weakening Dollar oil price/Rand oil price. If and when we develop our shale assets, we think that the economic benefits for South Africa, because of the cheaper energy source, would offset the potential negative impacts of a decreasing growth outside South Africa, due to a declining oil price and the impact on those geographies, which are oil exporters.

ALEC HOGG: Olof, just to close off with, the S&P was down last night by one-and-two-thirds percent. That brings its decline in the last little while to seven percent already. They only need three percent to get a fully-fledged bear market. Do you think it's going to get there?

OLOF BERGH: Gee, that's a tough question, Alec. Our short answer is that we still think that risks assets offer the best medium to longer-term prospective returns. We believe that the monetary authorities in the developed world will keep their interest rates lower for longer because we think that their economies are generally fragile. We know that the U.S. has shown some signs of increased growth in the last couple of quarters. Nevertheless, as a collective, we believe that the economies are fragile and not able to withstand rapid increases in interest rates. As interest rates are so low, asset classes (or assets themselves) justify higher valuations. Many economic commentators and asset managers have commented that the valuations of traditional asset classes are high. We think they'll remain high for some time, given that interest rates are so low, resulting in all fixed-income assets delivering very low returns and in so doing, justifying other risk assets.

Whilst are not surprised by the pullback, given the very strong performance over the last three years, we think it's time to add to risk assets like equities. Investors who do so and take that brave stance will be rewarded in the medium-term.

ALEC HOGG: Somewhat of a contra-cyclical view, but one that looks through the turbulence of the moment. Thanks to Olof Bergh who is an Analyst at Sanlam Private Investments.

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