A decisive move towards $100 per barrel

Oil prices moved firmly above US$90 per barrel this week, hitting a record $96.24 per barrel. While geo-political tensions and a Fed rate cut have driven the recent rally, we maintain our view that further increases are sustainable over the longer term. This week we consider the outlook for oil and the factors determining it.

As geopolitical events and the actions of the Fed have provided much of the recent oil price impetus, we would not be surprised to see a short term pullback. Despite this, our longer term target of $100 per barrel has now moved into focus and given the strength of the global economy, and more specifically the strength of the emerging nations, we find support for more upside in the longer term.

A key driver of this remains the unrelenting surge in global energy demand. Over the last fifty years, oil consumption has grown enormously, from 10 million barrels to a massive 86 million barrels per day. And this looks set to continue - The Energy Information Administration forecasts oil demand to rise to around 120 barrels per day by 2030.

The main reason for this demand growth has been the rise of the China economy. China's oil consumption has grown an average 7.5 percent annually in the past few years, seven times higher than the US. Almost 40 percent of last year’s oil consumption growth was due to Chinese demand and the country now consumes 9 percent of global production.

Even so, per capita oil consumption in China remains extremely low compared to many other countries. In fact, US per capita consumption is 14 times that of China. While the catch-up will take years, we believe that as the burgeoning Chinese middle class ramps up their consumption, this creates scope for further increases in oil demand.

The other emerging country to underpin demand for oil is India, currently accounting for around 3 percent of global oil consumption and also shaping up to be a key oil consumer in decades to come.

These two emerging nations account for about 12 percent of global consumption, which is about half that of the US. Given their rapid growth rates, we believe oil demand coming out of these two economic powerhouses will in time be enough to act as an offset to any US weakness.

With demand growing strongly, global production (supply) is not keeping up, hence the continuing rise in oil prices. The ability of global producers to respond to increases in demand is compromised by the fact that there is very little spare capacity, and higher prices are needed to entice a supply response. This is largely because most of the world's easily accessible and cheap oil reserves have already been found.

While there may be sufficient oil reserves in the ground, these projects are becoming very costly to access and commercialisation of these resources is only viable at a higher oil price. If these projects are not undertaken, supply is restricted even further, pushing prices higher again.

Nationalisation of oil, whereby major oil and energy fields are owned by the state rather than private enterprise, is another factor impacting oil supply. We believe that in general, national oil companies (NOCs) are not as adept or proficient at getting to oil reserves as listed companies with shareholder value to consider. As a result, some of these viable reserves controlled by these government run NOCs are left untapped or under utilised.

In addition, some of these governments may have different objectives besides increasing output, and this of course limits production. For example, many countries treat oil assets as cash cows, spend the windfall profits on various social programs and neglect to reinvest in the energy infrastructure. The long term result is declining or less efficient production.

OPEC's role in influencing oil prices is also significant. The cartel accounts for 40 percent of global oil production and has two thirds of the world's oil reserves. It is, in fact, the world’s only source of large oil production which can be supplied, in theory, relatively quickly.

Even though it has the ability to do so, the cartel has so far been disinclined to stabilise prices. OPEC officials consistently argue that there is enough oil in the market and they therefore state they are unwilling to increase production.

Clearly, as the cartel members' economic fortunes are linked to higher oil prices, members have an interest in keeping supplies tight. And given they are paid in increasingly worthless US dollars, OPEC have no incentive to see the US dollar price of oil decline.

These factors have combined to suppress the supply response to higher oil prices. In addition to this, increasing geopolitical risks have also been instrumental in pushing oil prices higher in recent weeks.

The Middle East region is fraught with difficulties from a geopolitical standpoint. Recent flare-ups have involved Turkey threatening to move into Northern Iraq to launch an attack against the PKK (Kurdistan Workers Party), in retaliation for the deaths of Turkish soldiers along the border region.

While not a major producer, Northern Iraq (controlled by the Kurds) is considered a ready production source of Iraq's oil reserves, with a number of major western oil companies active in the areas.

Exacerbating regional tensions, the US and Iran are at it again. Unlike the Turkish/PKK issues, this has the potential to really upset energy markets. On the surface the tensions are about Iran's intent to go nuclear, but the underlying issue is really about Iran's longer term ability to dominate the region following the US' failed Iraq strategy.

These tensions have always been bubbling under the surface, but in recent weeks the issues have garnered increased media attention, with higher energy prices an obvious casualty. Right now, there does appear to be a significant geo-political premium in the oil price and further pressures could push prices towards US$100 per barrel.

But just as easily, reduced political tensions, for the short term at least, could see oil prices retreat. Either way, the presence of such issues indicates the fragility of the energy supply chain and the strategic importance of oil.

From a charting point of view, we see the oil price rally of the past 10 months building significant upward momentum. Such price action is unsustainable for extended periods, and while prices are likely to continue higher in the near term, the risks have increased for a correction in the coming weeks.

Also marked on the daily chart, is the 200-day moving average, which depicts the longer-term trend. Although rising firmly, this average is currently at US$69.48, a significant discount to the current price.

However, in the longer term, a strong upward trend has been in place since December 1998. Despite the chance of near term volatility, given the resilience of this trend, we anticipate a continuation higher in the months and years ahead. We anticipate that oil prices in excess of US$100 per barrel are achievable in time.

Looking beyond geo-politics and the demand and supply dynamics of oil, we also find support for further upside in the weakening US dollar. The Fed's cut of 25 basis points in the official cash rate this week has transpired into a further slide in the greenback and oil prices predictably rallied on the back of this. After all, global oil prices are denominated in US dollars and as its value falls, more currency is needed to purchase a given amount of oil.

Even so, the oil price has not been solely driven by US dollar effects. As shown in the chart below, oil denominated in other currencies has also rallied.

In painting this long term bullish picture of oil, we should also point out that rising prices will at some point have a meaningful impact on demand. But so far, it appears that point has not been reached.

Notwithstanding this, given the limits to production, the scarcity of new reserves and the rampant rise in demand, we believe the oil price has the potential to breach our long term target price of US$100 per barrel in the not too distant future.

With regards to our portfolio, we recommend maintaining energy exposure with a view to buying on any corrections.