The black stuff
Ian Fraser talks to Baillie Gifford's Peter Cawston about the price of, and global demand for, oil and its potential effects on investment
The yellow cabs that ply the streets of New York are one of the great icons of the Big Apple. Some 90 per cent of these highly distinctive cars are Ford Crown Victorias, a model that was first produced at the tail end of the 1970s. Powered by five-litre V8 engines that - even with refinements - mean they average just 10 to 15 miles per gallon, they choke the city's streets. The vehicles are gradually being replaced by hybrid cars, but it will be another five years before they are all taken off the streets.
Peter Cawston is the fund manager of the Baillie Gifford North American Fund. He believes that this is a good illustration of his belief that the global demand for oil is not going to come down at any time soon. "It takes up to 50 years to change the energy-consuming capital stock of a country," he explains. Cawston also points out that, despite fears of global warming and a surging oil price since 2001, the average fuel-efficiency of US cars and light trucks has actually fallen since it peaked back in 1987.
Nor does Cawston believe that increasing the use of renewable energy is going to have much impact in the near future on the world's thirst for oil - partly because few green technologies appear to be competitive without subsidies or incentives of some description. He adds: "Frankly, ethanol is not economic. It makes a lot of sense to a farmer in Iowa because it increases demand for crops, but it doesn't make very much sense from an energy point of view because it is not an efficient way to produce energy."
Instead, given surging demand from emerging economies, including China, perhaps the best hope that we have for a return to cheap oil is an increase in production. Oil in the $50 to $80 range provides a strong incentive for exploration and production companies to seek it out in what are previously uncharted regions.
From 1986 to 2001, the price of oil averaged about $22 a barrel, which perhaps gave the world a false sense of security and is one reason for the current supply crunch. Energy at that price gave the oil companies little incentive to seek out any new reserves in remote areas where it is more expensive to get the black gold out of the ground.
This situation meant that there was little spare capacity when demand from China and the other emerging market economies started to soar in 2001. Since then, the oil price has risen in bursts, peaking at $78 per barrel in 2006. The price then drifted back down later in the year - giving a misplaced comfort to consumers and heavy users - before bottoming out at $55 a barrel in January 2007. However, in March this year, there was another sudden spike, prompted in part by concerns that Iran's kidnapping of 15 British sailors might cause a military skirmish in the Gulf. The price has since continued to rise.
Baillie Gifford is now forecasting that the price of oil is set to remain between the $50 to $80 per barrel range for the foreseeable future. Cawston explains: "There's a huge capacity crunch in every element of the oil business at the moment, which is what has been making it so difficult for oil businesses to increase supply fast enough to keep up with demand." One of the main reasons for this is a severe shortage of exploration equipment, including rigs, and a lack of trained personnel, such as petroleum geophysicists, another legacy of the 25 years when oil seemed cheap and abundant.
Much of this supply-side weakness can be traced back to Saudi Arabia's decision to flood the market with cheap oil back in 1986, a move that caused the world oil price to tumble from about $30 to about $10 in a couple of months. But it seems that neither Saudi Arabia nor Russia - the world's two biggest producers - can remedy the situation by pursuing similar action today, because spare capacity for oil is tight.
Publicity about global warming and the West's rush to subsidise renewables may be sending a message to oil producing nations to 'keep prices high', says Cawston. "The noises about global warming probably provide a convenient excuse for the major oil producing countries not to bother pumping out masses more cheap oil."
Another reason for the supply crunch is that western majors are increasingly finding that they are barred from territories where a great deal of easily accessible oil is known to exist, by governments that have decided to take control of production. This has forced the multinationals into drilling to great depths in the Gulf of Mexico and to mine the oil sands of northern Canada.
But projects such as these will not necessarily lead to plentiful new supplies of oil in the short term. "The current evidence is that most of the non-OPEC projects are small, expensive, delayed, or all three," Cawston says. And to summarise the current production situation: "The trouble is that the people who could produce additional amounts of cheap oil don't want to do that - and those who want to can't." He believes that the oil price's current up-cycle is going to take longer to resolve than that of 1973-86 and suspects that the global economy will have to get used to oil in the $50 to $80 range - it might even break through the $100 per barrel threshold within the next three years, says Cawston.
So what does this mean for a stock-picking investment company such as Baillie Gifford? According to Cawston, those businesses in energy-intensive sectors, such as logistics, transport, paper and packaging, will be among the most vulnerable. However, he says many players in such sectors should be able to pass on their higher energy costs to consumers, so perhaps the bigger threat could be inflation.
When looking at exploration and production companies, Baillie Gifford's managers consider emerging-market players that have access to low-cost reserves, such as Brazil's Petrobras and Russia's Gazprom. Current oil market dynamics mean that the oil-services players, especially the technologically advanced businesses, such as Schlumberger, could enjoy many years of boom.
The light at the end of the tunnel for the price of oil is that, once more rigs are built and more trained personnel become available to hunt for oil, the costs of finding and producing it will then inevitably fall. At some time over the next 10 or 20 years, significant major new supplies may well come on stream which could, in the end, usher in a return to oil at $30 per barrel. "The era of easy oil has seemed to be over several times," Cawston says, "but more oil has always been found. In the long run, there may not actually be a major problem with supply."
Who knows, that might mean it would make economic (if not ecological) sense for a New York cabby to reintroduce a Ford Crown Victoria cab to the city's streets. However, if governments do get serious about tackling climate change, and therefore oil consumption, says Cawston, that could then knock long-term growth in oil production on the head for good. "Incentives to produce energy from other sources would continue to rise and incentives to produce energy from existing sources would continue to fall." So, it'll be back to the hybrid then.
Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly. The value of your investment and any income from it can fall as well as rise and you may not get back the amount invested. The views given should not be taken as fact and no reliance should be placed on these when making decisions about investment.
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