Oil prices likely to rise to US$60, says Investec fund manager

An oil platform off the coast of Spain. Oil prices plunged to a 12-year low of US$27.88 per barrel in January before recovering to US$50 in June. The disruptions in the supply chain, for example through the Canadian forest fires, have reduced supply,
An oil platform off the coast of Spain. Oil prices plunged to a 12-year low of US$27.88 per barrel in January before recovering to US$50 in June. The disruptions in the supply chain, for example through the Canadian forest fires, have reduced supply, says Mr Tom Nelson of Investec Asset Management.PHOTO: BLOOMBERG

Falling supply from US shale producers, rising demand from developing world among factors

In the latest in our series featuring fund managers and leading market experts, Mr Tom Nelson, head of commodities and resources at Investec Asset Management, gives his outlook for the volatile oil and commodities market.

Investec is an investment management company that started in South Africa in 1991. It manages approximately US$109 billion (S$148 billion) for clients all over the world.

Oil prices plunged to a 12-year low of US$27.88 per barrel in January this year before recovering to US$50 per barrel in June.

The disruptions in the supply chain through the Canadian forest fires and rebel activities in Nigeria have reduced supply, which prematurely caused prices to increase, according to Mr Nelson.

These external disruptions that reduce supply function within the larger landscape of longer-term factors such as technological advancements and economic growth in emerging countries.

FOCUS AND DIRECTION

The commodity world is changing, we can see the end of the age of oil, and the move towards the decarbonisation of the transport sector. We would want (to invest in) companies that are clear on how they are going to position themselves.

'' TOM NELSON, head of commodities and resources at Investec Asset Management.

Technology can both add to the supply by lowering the cost of production for shale producers, and decrease demand for oil by offering alternative energy sources. At the same time, the increase in petrol demand from emerging markets may also raise the demand for oil.

These factors cause the demand and supply curves to shift constantly, resulting in fluctuations in the oil and commodities market.

Against this backdrop of volatility, Mr Nelson explains the strategy adopted by the Global Energy Fund he manages to ride on the oil prices the firm predicts will rise.

Q What is your outlook for oil prices for the second half of the year?

A We had quite a bit of improvement in oil prices - from US$27 to US$50 in just five months this year. Our forecast is that by the end of the year, oil prices may increase to around US$60. The reason for the increase is relatively logical.

Supply is falling, particularly outside of the Organisation of Petroleum Exporting Countries (Opec); in the case of the United States, shale production.

Demand continues to be strong in the developed and the developing world. For instance, we saw a surprise increase in petrol demand this year from India. We estimate overall demand is up 400,000 barrels per day year-on-year in India.

The more pressing question is: How much higher will prices go?

Our analysis suggests prices will increase till shale producers are incentivised, and production is stimulated again. Then, the increase in supply will slow down the increase in price.

We think this incentive price, calculated based on the cost for US shale producers, is likely to lie between US$50 and US$60. This price is exceptionally important for them since, at the moment, their production is falling due to the low prices that prevent them from breaking even. Whether it is indeed so is the biggest question in the oil market today, in my opinion.

Looking to 2017, there is another aspect to all of these, which is Opec, and specifically Saudi Arabia. Saudi oil policy changed suddenly around 2014 to become more aggressive in fighting for market share instead of being a balancing influence.

Very few people can predict Saudi oil policy and strategy. At the moment, we believe Saudi Arabia is reasonably happy because the oil market is rebalancing naturally (the price mechanism is signalling to producers and consumers to affect demand and supply).

But based on our analysis on the oil price they need for their own domestic spending, we think Saudi Arabia would be happy to keep it that way if prices increased to US$60. If they were to continue producing at the same volume as they do now, in 12 months' time, their domestic revenues will be 20 per cent higher. That isn't bad for them.

Q Where do you see opportunities in the oil sector?

A We believe oil prices are likely to continue rising in the second half of the year and so we are positioned for an improvement in the oil price.

In our fund, we overweight the upstream companies, specifically in exploration and production and underweight the defensive parts of the market - that typically do better in poorer times - such as refining, and oil transportation. For example, in refining, the business can benefit from lower input prices (in poorer times) and stronger demand.

The companies we like are companies that are big enough and have strong enough balance sheets to withstand this volatility in oil prices. We prefer (now) US names like Conoco Phillips, Occidental, Hess and Anadarko. These are large-cap companies which have the flexibility to deal with periods of commodity price weaknesses.

We also favour integrated oil and gas companies like Royal Dutch Shell that are responding positively to the current oil market. For the first time in 15 years, Shell made a commitment to focus on returns to shareholders instead of focusing on growing volume and becoming the biggest in the market.

Q How will the traditional commodities sector be affected by alternative energy sources?

A Renewable energy technologies and sources will play a greater role in the global energy system. Their effect has been the most obvious on the coal industry. Coal has come under increasing pressure from natural gas and renewable energy.

Sixty per cent of global oil demand today is in transportation. The cost deflation in solar power has been around 80 per cent in the last five years. If we can achieve a battery technology which is safe and cheap enough to move the world away from combustion engine to battery and electric vehicles, there would be a huge change in global oil demand.

Around 5 per cent of our Global Energy Fund is in alternative energy. We prefer solar and wind energy because of the promising advancements in these technologies.

Q What are your views on the commodities market?

A The sector has been in a bear market - or a weak pricing market. This period of weaker pricing has reduced supply.

What we hope for this sector is that companies be more disciplined so that as commodity prices begin to normalise and move higher, they can focus on shareholder returns and profitability.

The commodity world is changing, we can see the end of the age of oil, and the move towards the decarbonisation of the transport sector. We would want (to invest in) companies that are clear on how they are going to position themselves. Companies with disciplined capital allocation and are thinking about shareholders, corporate and social responsibility. Three of these companies are Royal Dutch Shell, Schlumberger and EOG Resources.

Q What is the impact of Brexit on the commodities sector?

A The Brexit decision has increased market volatility and brought concerns around economic growth and Europe and elsewhere. We believe that commodities and natural resource equities will be relative beneficiaries from the recent market volatility and Brexit. This is especially the case for Britain and European investors, who will see resource companies as a "safe haven" as they provide global exposure and with their revenues in US dollars they also provide a hedge against local currency devaluation.

A growing concern is that these currency declines may point to softening economic growth and commodity demand for this region. However, the fundamental impact on demand growth and market balances is extremely small. Oil demand is not very sensitive to GDP changes, and, for oil and metals, Europe represents less than 20 per cent of global demand.

Nevertheless, Brexit has introduced more economic uncertainty which will likely further curtail investment and limit supply growth, supporting higher commodity prices for longer.

Q What is your advice to the retail investor?

A Market timing in this sector is very difficult.

We recommend a dollar-cost average strategy for making an allocation and believe that after the prolonged weakness in the natural resources sector, this is now an attractive buy-and-hold investment on a three-year view.

A version of this article appeared in the print edition of The Sunday Times on July 03, 2016, with the headline 'Oil prices likely to rise to US$60, says Investec fund manager'. Print Edition | Subscribe