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Oil The Naked Reality

At the start of the year, crude oil prices had fallen dramatically from the all-time highs reached a mere few months earlier. Oil bulls such as ourselves were increasingly in a distinct minority as surely the market's phenomenal run had come to an end.
Fast forward to today and oil has made a dramatic recovery - hardly surprising in our view. Long-term supply and demand fundamentals are still firmly in favor of higher prices. That said, short term volatility and weakness will periodically punctuate the trend.

Demand this year according to the International Energy Agency (IEA) is set to grow by 1.8% to 85.7 million barrels per day (mb/d).

A slowing US economy does not appear at this point to have had a major impact. Meanwhile, China and India are still expecting healthy growth this year of 6.4% and 3.8% respectively.

It is not hard to see why these two Asian giants are leading the way. China's first quarter GDP came in at a buoyant 11.1% higher, while India could 'only' manage 9.1%. This level of economic activity makes large energy demands, of which oil is part of the solution.

Energy requirements will grow further as hundreds of millions of people across Asia migrate to cities over the next decade. This is particularly true given the low levels of usage Asia currently experiences on a per capita basis.

Let us look at the numbers internationally. Each year the USA consumes roughly 28 barrels of oil per capita, while Japan's annual consumption is 18 barrels per capita.

By contrast, despite massive growth over the past 25 years, China's per-capita oil consumption is just 1.7 barrels. India's per-capita consumption is just 0.7 barrels! This data suggests that both China and India are still in the initial stages of the industrialization and urbanization cycles.

As such not only is the number of consumers growing, in the future as society becomes more affluent, usage at the individual level will also rise!

Little wonder then that forecasts from America are showing global demand rising to 90.7 mb/d in 2010 and 118 mb/d by 2030. Along with America, Asia's dynamic duo will drive nearly half the increase.

Meanwhile, back to the present and world oil supply during April 2007 was 85.5mb/d. If we assume further modest increases to supply throughout 2007, then tightness in the oil market becomes apparent.

Is it any mystery then that the price of oil reacts so quickly to any hint of a supply disruption?

Although OPEC currently has some spare capacity, the buffer is not sufficient to make up for a major event such as Iran withholding exports or further shut-in of production in Nigeria.

Not only that, but America's Energy Information Administration (EIA) is calling on OPEC to increase production in the second half of the year in order to prepare for winter heating demand. Should the cartel comply (which is unlikely before September at the earliest), the already slim buffer gets even thinner.

Recognizing the precarious situation of energy markets, many governments around the world are seeking alternatives to oil. This drive will continue in the future, as environmental awareness creates the conditions for change. Transportation, which is a critical factor in demand, has received a lot of attention recently.

Biofuels are being touted as a magic bullet to solve our energy dilemma woes. While these can certainly make up some of the volumes, the energy efficiency and environmental friendliness claims are disputable.

Nonetheless, America's President Bush has set a target of reducing petrol usage by 20% over the next decade and biofuels are expected to play a large part.

OPEC's response to this threat to a major market was unveiled last week. In order to increase supply to meet demand projections, the cartel is planning to invest around US$630 billion in infrastructure over the next 13 years.

However, if future demand were going to be co-opted by Brazilian sugar cane and American corn farmers, then the massive investment program would have to be revisited. Clearly OPEC is drawing a line in the proverbial sand: effectively saying, we will invest in future production, but the currently projected high level depends on a strong end market.

This development is very significant because even with OPEC investment, supply was still in our view going to struggle to keep up with demand. Should OPEC spend less, the long term ramifications would almost certainly be much higher prices.

This also leads into what in our opinion is emerging as one of the greatest threats to the world's oil supply - energy nationalisation and state control.

Governments are not renowned for the ability to outperform the private sector in matters relating to innovation and effectiveness. However, today non-national oil companies are getting less and less access to oil reserves.

This is important because oil in the ground is no use to anyone. So although the world has adequate oil reserves, as Bill Clinton's political strategist James Carville might have quipped, "It's the production, stupid".

State run companies in general are not as adept at getting oil out of the earth's crust. There are several reasons for this but they all principally stem back to what happens to the oil revenue.

Whereas public companies will use large portions of cash flow for exploration and development, nationals may have other 'calls' on the cash or become instruments for political axes to be ground. The result can be an operation starved of investment and long term decline as the cream is skimmed off and spent on non-productive activity.

Unfortunately for the oil bears, national oil companies are sitting on the majority of the world's oil reserves. And rising energy nationalism in South America and Russia do not bode well for a significant boost in global output as the trend towards state control increases.

Geo-political tension is also a source of support for higher prices. While the world's hotspots are well established, a growing threat is gaining steam in the Middle East. Often this tension is portrayed as a conflict with the West, however an unfortunate (one of many) side effect of America's foray in to Iraq is the increase in sectarian violence within the Muslim community.

Iraq's Sunni and Shiites Muslims are it seems engaging in ever increasing levels of violence. The threat to world oil supplies would really go off the charts if this conflict were to spread to the regions powerhouses Saudi Arabia (Sunni) and Iran (Shiite).

Finally (and not related to oil's supply or demand), we believe the US dollar will come under increasing pressure. This weakness will further underpin oil prices in our opinion. As the dollar depreciates, oil producers will demand more of them in exchange for their oil.

The bottom line is that as the world continues to grow at a healthy pace led by exceptional growth in emerging markets, aggregate demand for energy will continue to rise. Satisfying that demand will be a challenge even under ideal conditions.

So fundamentally we believe support for oil remains solid but where do we stand from a technical perspective?

The chart at the top depicts the Light Sweet Crude Oil front month futures contract. This is often used as a proxy for oil prices worldwide.

As this chart shows, for the last three months prices have been contained to a consolidation range between resistance at US$68.09 and support at US$60.68. Such price action is unsurprising in our view given the robust rally from a corrective low of US$49.90 in January.

More recently, there has been a bias towards the upper end of this consolidation range. We believe this demonstrates underlying upward momentum, which will lead to an eventual break out to the upside. In our opinion, such a move would allow for a retest of the July 2006 all time high of US$78.90 in the coming months, with US$100 a barrel achievable within time.

We believe supply's tightly run race with demand over the next decade will keep upward pressure on the price of commodities we rely most on for our energy today. As such, we continue to maintain an over-weight exposure to the oil and gas sector.

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