Rule 1: watch out for bubbles
In reality, this oil price ramp up looks, if anything, even more out of touch with physical market fundamentals than last year's spike. In the first half of 2008, oil bears could argue that a slowdown was coming and that demand would fall. But there was no denying that supply, while adequate, was right at the margins of safety. There was little spare capacity in the system. Surplus production capacity across the Opec oil producer cartel was at a mere 1m barrels per day (bpd), a 30-year low. That is not the case now. With global demand having tanked from perhaps 86m bpd to around 83m bpd, Opec spare capacity in the first quarter this year was around 4m bpd.
To experienced industry-watchers, this level of spare capacity is itself in turn a bearish portent for oil prices. As BP chief economist Christof Ruehl noted at the launch of his company's annual Statistical Review of World Energy in early June, those betting on prices holding firm at current levels in the near term may have cause for concern. History shows that idle Opec capacity does not in general stay idle for very long – some producers in the cartel inevitably start to cheat on their quotas to gain extra revenue, and that temptation is especially hard to resist when oil prices are high.
On top of that, the world has just seen the largest drop in oil consumption since the early 1980s. Oil in storage is high in historic terms, and despite shut-in Opec production, global oil supply is still exceeding demand. As Mr Ruehl says: "A return to high rates of economic growth may prove elusive for some time". In short, it is hard to see how fundamentals can justify the kind of appreciation in the oil price seen in recent months.
Speculation, on the other hand, explains a lot. A growing weight of speculative financial interest in the oil price has been obvious through this period, as it was leading up to oil's all-time peak last year. This time around, however, exchange-traded funds (ETFs) have been notable as a vehicle of choice for oil price speculation, as opposed to the more generalised commodity indices favoured last summer. ETF Securities said in May that inflows into its suite of oil-tracking ETFs totalled $954m (£579m) in the first four months of 2009, more than twice all inflows seen throughout 2008, and representing an annualised growth rate of 544 per cent. And LCM Commodities has pointed out that one US-listed oil ETF alone accounted for some 15 per cent of interest in front-month oil traded on the New York Mercantile Exchange (Nymex), the world's biggest oil futures market.
Rule 2: $70 is the top, for now
Any good is worth what someone else is prepared to pay for it. So why are we convinced that the market is 'wrong', and why have we identified $70 as the upper limit of what is a 'fair' price for oil?
We looked at what people in the industry think. BP chief executive Tony Hayward, speaking at the launch of BP's statistical review this month, thinks that a fair price for oil lies somewhere in the $60-$90 a barrel range. His reasoning is that only at a floor above $60 a barrel can core producing countries in Opec afford to both maintain infrastructure and meet their stated social spending commitments.
If prices drop below this level, oil infrastructure spending will suffer first, limiting production capacity and supporting the oil price. On the upside, Mr Hayward also feels that the marginal cost of supply for emerging sources of production, such as deepwater offshore Angola and Canadian tar sands, means the upper band of sustainable prices is towards the $90 mark.
Dr Ed Morse and Daniel Ahn of LCM Commodities have a more specific price band in mind. They have developed a model matching the five-year forward oil price to the US Bureau of Labor Statistics' producer price index (PPI) for oil and gas industry services. Between January 1994 and October 2007, movement in the five-year oil price was very closely tied to movement in the PPI index.
Their chart (below) shows the five-year forward oil price plotted against both the plain-vanilla PPI index, and the PPI adjusted for dollar fluctuations. You can see clearly that the five-year price spiked upwards after October 2007, morphing into the oil price bubble which peaked in July last summer. While the five-year oil price and PPI data series briefly converged again around January this year, oil has since run away upwards again into what looks like the beginning of another bubble.
Right now the PPI series predicts the 'fair' five-year price of oil to be around $60 a barrel. These arguments boil down to how much oil costs to produce, and what return oil producers need to earn above that cost. Such thinking is in stark contrast with the price-spike-to-infinity models that characterised the oil price fever of last year, which effectively said that prices had to rise sharply enough to destroy demand because a step change in supply was simply impossible. As long as 4m bpd of spare Opec capacity remains idling, however, it clearly is possible.
It's also notable that consensus opinion has shied away from endorsing a new price spike. This time last year, you could count on two fingers the number of top-tier investment bank oil analysts prepared to argue that $100-plus crude prices were cloud-cuckoo land. This time, the voices of moderation are the majority. Citigroup is using $65 for its long-term oil price assumption, while Credit Suisse is sticking to $70.
Rule 3: don't buy shares as oil price proxies
The standard response to rising oil prices is to buy shares in oil producers. But it's arguably the least efficient way to play black gold. Since the start of January, Nymex West Texas Intermediate (WTI) futures (the global benchmark for oil) are up some 80 per cent. A basket of mid-cap oil exploration and production (E&P) plays, including shares such as Cairn Energy, Dana Petroleum and Tullow Oil, is up around 40 per cent, while the three larger integrated oil majors (BG Group, BP and Royal Dutch Shell) are flat, in aggregate.
You might object that it would be better to focus on companies with direct exposure to the oil price through near-term production and reserves growth potential. We would beg to differ. Citigroup finds that using $65 a barrel as its long-term oil price, Tullow Oil, Soco International and Addax Petroleum look particularly highly valued. In Tullow's case, a share price above £9 is almost at the limit of what fresh exploration success could realistically add to its existing reserve base. And Addax's and Soco International's shares are above Tullow's. In other words, it is largely the high oil price that is keeping the shares at current levels – and if crude weakens, so will the shares, because everything else is already in the price.
Rule 4: M&A won't ride to the rescue this time
If the oil price doesn't support share valuations, what about potential takeover premiums? After all, the majors are short of prospects for reserve growth and it's often cheaper to buy new barrels than find them. Heritage Oil, Addax Petroleum, Dragon Oil and Venture Production are all the subject of takeover activity.
All true, but private sector corporate players are battening down the hatches and pulling in their horns. Majors such as BP and Shell have cut development expenditure to conserve cash. Why would they buy more opportunities when they are delaying funding the ones they have already?
Much of the acquiring is being done by cash-rich state-owned companies, who are picking off listed, mid-sized producers with decent reserves with nary a squawk of protest from shareholders in those firms. Look at Sibir Energy – less than a year ago, its shares were as high as 839p, but now its shareholders are taking 500p a share in cash from Gazprom. Or Dragon Oil, whose shareholders have been informed by major shareholder Emirates National Oil Company (ENOC) that it intends to buy them out, but only at "a modest premium". Only at Addax, where the Chinese and the Koreans are fighting it out for control, does there appear to be a realistic prospect of a bid battle.
Rule 5: look for undervalued resources
So, if we don’t trust the oil price, and mergers or discoveries aren't likely to support share prices, what should we be looking for? The answer is reserves that aren't yet in the price. A good example is Heritage Oil, which is in the throes of merging with Turkish company Genel Enerji, its partner on the large Miran discovery in the autonomous Kurdish region of Iraq. Based on a $70 long-term oil price, Credit Suisse estimates that the merged entity's likely reserves could be worth 675p a share, against Heritage's current price of 514p. This is based on an estimate of what the proved reserves, plus an estimate of what new exploration could add, adjusted for the probability of such exploration being successful – the so-called 'risked upside'.
On top of this, there's a possible 2,000p a share of blue-sky potential upside from prospects that aren't in net present value models right now, most of which (some 1,700p) comes from a collection of licences in Kurdistan that are being brought in by its Turkish merger partner. This is known as 'unrisked upside'. The analyst has not attempted to estimate the probability of exploration success, and has merely indicated what it would be worth if it happened.
But this is exactly the kind of play we are interested in right now – with a wide range of high-quality prospects in a near-term exploration portfolio, but not yet solidified enough for the City to price in with any great confidence. Even if oil falls, there is great potential for incremental jumps in valuation, as ongoing drilling and other technical work begins to derisk resource estimations for discoveries and trigger consequent boosts to analyst net asset value (NAV) calculations.
Conclusion
If our short set of rules makes it sound a challenge wringing solid value out of the oil sector right now, that's because we think it is. The oil price looks dangerously toppy, in our view. The problem with calling any bubble is, however, looking stupid while it keeps inflating. As John Maynard Keynes is thought to have said, the market can stay irrational longer than you can stay solvent. But we would rather sit this spike out than encourage people to buy into names we normally favour, when the main force driving the bandwagon is already drunk at the wheel.
