Wed | Mar 21, 2018

Walter Molano | Making the wrong bet on oil

Published:Friday | November 24, 2017 | 12:00 AM
In this 2012 photo, a ship docks at the refuelling station in Fujairah, United Arab Emirates. World oil prices have been recovering, having failed to hit the lows predicted earlier this year.

Many people were caught wrong-footed by oil prices this year.

Having been convinced that electric cars and alternative energy sources, such as solar and wind, were going to put the hydrocarbon industry out of business, they were ready to consign the sector to the trash heap of history. They thought, if anything, the fracking revolution was going to readily provide the trace amounts of oil products that were needed to fuel modern industry.

Lured by the piper's song that oil prices were going to fall to US$10 per barrel, investors dumped their energy positions. Unfortunately, they were wrong to do so.

Three fundamental factors - demand, supply and political risk - turned the rout into a rally. Having more than doubled from its lows, oil prices are poised to move even higher.

On the demand side, both the International Energy Agency, the IEA, and the Organisation of Oil Producing Countries, OPEC, have increased their forecasts for global oil demand in 2017 and 2018. During the second quarter of this year, IEA reported that demand rose by 2.4 per cent year-on-year. This forced the Paris-based agency to raise its annual forecast for 2017 to 1.7 per cent year-on-year. For 2018, it is maintaining a conservative forecast of a 1.4 per cent year-on-year increase.

China demanding more energy

OPEC was more strident, forecasting global oil demand to crest over the 100 million barrels per day by the end of the decade. Unfortunately, the organisation may be off by a year. Greater prosperity in China and India are resulting in higher demand for energy.

China continues to expand its insatiable thirst for oil by 15 per cent year-on-year. This year, Chinese oil demand is expected to be close to 11 million barrels per day (mbpd). Although the Chinese economy has cooled from the double digit growth rates that were posted at the start of the decade, GDP growth still remains north of six per cent year-on-year. This rate of growth is actually having a bigger impact on the global economy than when it was expanding at a pace of 12 per cent year-on-year.

This is because the size of the Chinese economy is now much larger. Moreover, there are no signs that China is slowing down. Last year, 28 million cars were sold in China. This is compared with the 21,000 electric cars that were sold. Even though, there is a lot of excitement in the Chinese electric car market, it still represents a minuscule slice of total car sales.

The same thing is happening in India. With a population equal to China's, and an economy that is growing at more than seven per cent year-on-year, it is becoming one of the hottest automobile markets in the world.

Moreover, there has been a lot of hype about the Indian electric car market. President Narenda Modi has targeted them as a way to reduce his country's carbon emissions. However, the reality is that car sales have been growing 12 per cent year-on-year, with electric cars representing only a sliver of sales.

Not surprisingly, oil demand has been rising at a similar pace. Last year, India's oil demand was 4.3 mbpd, and Indian economists expect it to rise to 10 mbpd by 2040.

Unstable oil proces

While oil demand has been moving up steadily, oil production and supply has been moving down. Oil capital investment has dropped 40 per cent from the highs in 2014, and it has only recently started recovering. This has been due to the increase in oil prices.

Just in Latin America, approximately, 2.0 mbpd in oil production has been lost, principally in Mexico, Venezuela, Colombia and Argentina. The North Sea oilfields have reached the end of their productive life, and many platforms are being dismantled. There have been a few notable discoveries in Mexico and Norway, but it will take years to bring them up to speed.

Other than that, the pace of oil discoveries has been the lowest in decades.

Last of all, political unrest in the Middle East could cause important disruptions in oil production. The recent political purge in Saudi Arabia has raised fears of factionalism and wide spread social unrest. Saudi Arabia's social structure is tribal, with deep schisms between sects.

A fragmentation of the country has been averted by allowing the succession line to be horizontal, rather than vertical. This gave competing clans and tribes a chance of becoming the monarch, and sharing the spoils.

However, the monarchy appears to be moving towards a vertical succession system, which is rifling feathers among the other tribes and factions.

At the same time, tensions between Saudi Arabia and Iran are heating up. Last week, Riyadh recommended all Saudi's to leave Lebanon, which is in the political grip of Iran. Any unintentional incident could trigger a confrontation that could degrade into a shooting war, as well as a conflagration of the entire region.

Saudi Arabia, alone, produces 12 mbpd, without including other large regional producers, such as Iraq, Iran, Kuwait and the Emirates. Production disruptions could easily send oil prices into the triple digits.

Therefore, underestimating global oil demand, supply and the political situation in the Middle East, could deliver a nasty surprise for investors who headed the siren's call that oil prices were permanently going lower.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.