Profit as oil spikes, slumps, then takes off again

published 5 June 2009

Last month, the Venezuelan army rolled into the port town of Maracaibo. Sent there by President Hugo Chavez under the auspices of a crackdown on local drug cartels, the soldiers quickly seized the port blaring the national anthem as they swarmed into the shipyards. But the president's real goal soon became apparent. Maracaibo, as it happens, is the biggest oil-exporting port in Venezuela.

Reeling from the 60% plunge in the price of crude, which has hit Venezuela's coffers hard, Chavez had come up with a plan to avoid having to pay the oil services firms operating in the region simply seize control of their assets. "We have started to nationalise all these activities connected to oil exploitation," explained Chavez from a confiscated boat sailing across Lake Maracaibo.

Unfortunately, it seems Hugo Chavez has learned little from the oil crisis. The move "could lead to further declines in the Opec nation's oil production", said CNN scaring off foreign investors in the process. But Chavez is not the only one. Years of cheap oil and a "just get it out of the ground" attitude to oil exploration left the oil industry hopelessly unprepared for the oil boom of recent years. As oil burst through $100 a barrel, years of neglect had left the industry desperately short of the equipment and expertise needed to scope out new reserves. The day rates for deep-sea oil drills surged. Experienced petroleum engineers and geologists went through several tax brackets as the backlog of oil projects stacked up.

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Now it seems the oil industry is set to make the same mistakes all over again. That might sound absurd while oil is surging past $70 a barrel. But as we'll explain shortly, the current rebound has very little to do with the quantity of oil actually being pumped and consumed. It's mainly about investor over confidence and Chinese stockpiling, with a bit of dollar weakness thrown in for good measure. And because they have little faith in the rebound, oil majors are slashing investment as fast as they can. But this merely sets up the conditions for a series of big future spikes in the price of oil. Get ready for the Great Energy Crisis Mark 2.

Paralysed by fear of a Japan-style lost decade at the turn of the year, investors' appetite for risk has returned with a vengeance. The Chinese, for one, have wasted no time snapping up barrels of oil while it's still comparatively cheap. And Opec has cheered on the stunning recovery in Chinese demand for oil, announcing that the global economy could now support an oil price in the region of $75 to $80 a barrel.

But don't get too excited. As Julian Jessop at Capital Economics puts it, "there are still reasons to be cautious about the prospects for commodities". This oil bounce has very little to do with genuine demand or a real recovery in the global economy. It's partly down to the dollar (see chart). As the greenback has been pounded over the last few months, oil priced in dollars has become a lot cheaper to buy on international markets.

And that's what's driving Chinese demand, rather than a genuine need for oil. With China concerned about the value of the dollar, it would rather be holding onto real assets than more Treasury bonds. And this notion is backed by a recent study from Bernstein Research. After weeks of tracking oil tankers with satellites and using time-lapse images to observe the build-up of fuel storage in Chinese ports, the group has concluded that Beijing is building a formidable strategic reserve of oil.

But it will take more than a cheap buck and fears about inflation to keep oil at these levels. The truth is that the current supply-demand picture for oil is grim. Whole industries are losing their thirst for oil from cars to airlines and chemicals. The scale of the slump is best illustrated by global electricity consumption, which the International Energy Agency (IEA) expects to fall by as much as 3.5% this year. That would mark the first year that global electricity consumption has contracted since the end of World War II.

Meanwhile, OECD inventories of oil are nearly back to their highs of the past decade, last seen in 2006. In recent weeks, America's oil inventories have been higher than at any point since September 1990, in the run up to the first Gulf war. "There is little room left to store any more crude," says Jeff Currie of Goldman Sachs. So oil traders have been hiring tankers to store it offshore. Rich countries stocks now cover 62 days' consumption the most since 1993. The average over the past five years has been 52 days' worth.

In short, says James Hamilton on RGE Monitor, "had it not been for the added demand from inventory accumulation, the price would have fallen further". But this can't go on forever. China's four emergency fuel tanks are full and at these prices, physical traders will become increasingly tempted to start selling oil again. When they do, oil could crash to the February lows of $35, reckons oil analyst Dave Cohen.

The oil industry is certainly not taking any chances with this rebound. It is already unwinding production at a fierce rate. In the last six months, the top 50 oil majors have cancelled more than $150bn of investment, says the IEA. Plans to invest in depleting oil fields from Siberia to Venezuela are being shelved. Cambridge Energy Research Associates reckon that 5.5 million barrels per day of new capacity will fall by the wayside in the next few years. That amounts to a third of the projected rise in output by 2014.

Of course, it makes good sense for the oil industry to cut back when demand is diving. The normally ill-disciplined Opec members have apparently cut daily production by some 3.3 million bpd leaving them with as much as six million bpd of spare capacity to bring back into use when demand picks up. But it may not be that easy. The idea that oil nations can suddenly ratchet up production is a bit of a myth, says Brian McBeth of Oxford Consultancy Group. "Opec, for example, maintains that Venezuela can pump 2.6 million bpd, but that figure isn't credible we would see a much bigger build-up in foreign-exchange reserves if it were true." The Saudis boast they can ramp up production to 12 million bpd, but "I estimate it would take them 1824 months of investment to get near that", says McBeth.

On top of that, many of the constraints to expansion that helped drive the last boom are still there. There is still a shortage of experienced engineers and geologists, says Iain Manson of recruiter Korn/Ferry a problem it will take a decade or more to set right. And there is little sign that governments are willing to grant oil firms access to the most promising territories for exploration, says The Economist. Iraq's plans to farm out contracts to foreign firms are years behind schedule. US sanctions are crippling oil investment on Iran. And Nigeria's government has had no success quelling insurgency in the Niger delta, where rebels regularly disrupt the oil supply by hacking into pipelines. In any case, oil firms have been burned by the likes of Venezuela, and are likely to be cautious about investing in new reserves in countries with hostile governments from now on. Without their aid, many nationalised oil groups will struggle to maintain and expand production.

And while small independents are being hammered oil firms only managed to raise £23.6m on Aim in the final quarter, compared to £229m the three months before some of the oil giants have continued to invest. Petrobas, controlled by the Brazilian government, plans to raise its investment by 55% to $174bn over the next five years. As others cut back, this will put these companies in a better bargaining position with oil services groups. We have a look below at how you can prepare yourself for the next oil spike and also give tips on how to take advantage of any pullbacks along the way.

Smaller oil firms suffered badly as oil prices fell back, and with prices likely to be volatile as the mood of global investors veers between blind optimism and the depths of despair, we'd stay out of the sector for now. However, in the UK, the oil majors still look good value. Royal Dutch Shell (LSE: RDSB) trades on a p/e of eight, and yields 6%; while BP (LSE: BP) is on a p/e of ten and yields 6.8%.

The Tupi Field is expected to contain between five and eight billion barrels of oil. The firm is currently under scrutiny for allegedly dodging $2.2bn in taxes and for overpaying for pipelines and ships. But it is still ploughing ahead with a $174.4bn spending plan to develop its reserves, the world's largest corporate investment programme, which should stand it in good stead in the longer term. The stock currently trades on a forward p/e of 14.8, according to Morningstar.

One firm benefiting from Saudi Arabia's ongoing investment in its oil infrastructure is engineer Kentz (LSE:KENZ). The company provides mechanical, electrical, engineering and construction services for the oil and gas industry. It has a healthy backlog of orders, which rose 68.3% last year to $1.01bn. It hopes to complete half of this work in the year ahead. It also has $154m in cash and is currently bidding for new jobs worth $2.1bn this year. Kentz trades on a forward p/e of nine and offers a 3.14% dividend. The stock has risen 17% since we tipped it at the start of last month, but we'd still be holding on to it.

These stocks are worth holding on to they can survive turbulence in the oil price, and in the long run will benefit from continued demand for crude. But in the shorter term, how can you profit from the likely pull back in the oil price? One way of betting on a falling oil price, but at the same time cap your maximum losses, is via the oil options market. You can play this through a broker such as IG Index.

Oil futures prices are linked to the price of a physical barrel of oil. For example, say the oil future currently trades at $70 per barrel. You could pick a put option with a 'strike' price of $50 (this can be varied up or down depending on how bearish you feel) and an expiry of October with a bid to offer spread quoted as $0.55/$0.75. The higher the strike price, the more expensive the put options, so the higher these spread prices will be.

To just recover the premium paid you now need the futures prices to drop to $49.25 ($50-0.75) at expiry. That way your profit is 0.75 cents x £5%, or exactly the £375 you paid up front as a premium. Should the future fall below $49.25 you will make a profit. For example, if it drops to $45 when the option expires you stand to make a profit of £2,125 ($50-$45 x 100 cents x £5 a cent = £2,500, less the £375 premium). The further the price falls below the strike, the bigger the profit. You could also choose not to wait until expiry and sell the put option back to IG Index earlier, for example, if the price falls below your target before expiry.

Oil at $143 a barrel was very bad news for consumers, particularly in the car-dependent US. In fact, some even blame the financial crisis on the oil shock, rather than the collapse in the subprime market. How does that work? Well, economist James Hamilton argues that the availability of cheap petrol in the eighties and nineties resulted in the creation of sprawling suburbs outside major cities in America, as families set up homes further from the places where they worked.

But as the price of petrol rose, it put a huge strain on these families' household budgets as commuting costs consumed an ever greater proportion of their incomes. When interest rates rose, pushing up mortgage bills too, families simply could not afford their commutes any more and sold their homes at a loss. Eventually, says Hamilton, the falls in disposable income and house prices resulted in mortgage delinquency rates moving beyond a threshold where they threatened the overall solvency of the financial system turning a modest recession into a ferocious downturn.

We're not sure we buy the theory it seems more plausible that easy money and careless lending drove up both house prices and the oil price; high oil was a symptom rather than a cause of the crisis. But certainly, further spikes in the oil price could threaten any economic recovery. As Brian McBeth of Oxford Consultancy Group points out, a future spike above $150 a barrel would obviously cause debt-laden consumers even more trouble now that their finances look even more shaky.

In fact, we better get used to some serious volatility in the price of oil, reckons venture capitalist Shai Agassi. Oil is following a depletion pattern as we exhaust the oil wells that are easier to access, we have to spend more money to get at harder-to-reach reserves. So whenever the economy recovers, a spike in the price is more likely, because it costs more to get at the oil that's left. But the trouble is, that spike will also kill any recovery, by squeezing incomes and pushing up inflation and potentially interest rates. So forget the W-shaped downturn we could be facing the yo-yo recession.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.