The price of oil hit $140 this month, its highest price ever (in nominal terms). Considering that oil was just $20 at the start of the GSM revolution in August 2001, this has been a remarkable rise. Is it likely to stay at this price? Or even go higher? Could it come crashing all the way back to $20 as it did after the oil boom in the 80s? Given that oil accounts for over 90% of exports, how should the average Nigerian be impacted by this windfall and what should smart investors be doing to capitalise?

 

We last covered oil prices in June 2007 and at the time predicted that prices should top out at about $90 (though we did have the caveat that prices could spike higher due to unpredictable geopolitical events such as a war in the gulf). At the time, one reader did say that our $90 was pure fantasy, so we were both wrong and we must eat humble pie and revisit our assumptions.

There are many things that are driving the price of crude, most important, of course, are demand and supply. Other influencing factors are that crude is priced in dollars, which is a depreciating currency (the price of crude in Euros is only up 2.5 times compared to almost 5 times in dollars), and the effects of increased speculation on the oil market.

Demand for crude changes slowly and predictably and currently sits at about 85 million barrels per day. The key consumers are the US (24%), OECD Europe and Japan (27%), China (9%), Asia, minus China & Japan (10%), Russia and eastern Europe (6%), and the rest of the world (24%).
Demand grew 3% in 2004, 2% in 2005 and 1% in 2006. We had predicted that demand would be flat in 2007, but we were wrong. Demand grew 0.9% over 2007.

Demand in the US was flat (0%) in 2007. We had forecast a decline and had thought that the higher prices and threatened recession would cut demand. They are obviously much more resilient than we had thought, but we can’t believe that with prices now at $140 they can continue to resist. This year we forecast that US will decline (it would be tragic if we got it wrong two years running). The country is obviously in recession and the high prices are beginning to affect drivers and other users.

Demand in Europe declined 2.3% and Japan 3.6% (in line with our expectations), they obviously don’t have as much resilience as the Americans. We forecast that demand will be flat or decline by up to 1.5% over 2008.

China, the rest of Asia and the rest of the world increased their demand by 5.2%, 1.7% and 3.8%, respectively; again we had forecast a much more modest increase of only 2% in these regions. This year we have increased our forecast to 3.5% for China.

Overall, we expect demand to grow by 0.5% over 2008, down from 0.9% in 2007. A 1% decline in the US, Europe and other OECD countries, offset by a 3.5% increase from China and 2.9% from other non-OECD countries.

Whilst demand has been steadily growing, supply, on the other hand, has stalled. Crude oil production increased to 84.63 million bpd in 2005 (a 1.8% increase), but has since declined to 84.598 mbpd in 2006, and 84.548 mbpd over 2007.

Last year, we had predicted that supply would remain more or less flat, which has been the case (a 0.06% decline). However, given that for the first time ever oil production has declined for two years in a row, there is concern in the oil markets that production may have peaked and that the world may never be able to produce much more than 85 million barrels per day. If this is the case then $200 per barrel would be a steal.

The theory of peak oil was first put forward by Dr Marion King Hubbert, a geologist who worked for Shell. In the days before computers (1940s) Hubbert analysed all the oil field production data and realised that every oil field went through a similar profile of increasing output, followed by a peak, followed by declining output.

He then applied this model to all the oil fields in the US and predicted that production in the United States would peak by 1970 and then begin to decline. US production actually peaked in 1972. Hubbert missed by a couple of years because he had not factored in the finds in Alaska (production in the 48 continental states peaked in 1970 in line with his prediction), but even the massive finds in Alaska could only postpone it by two years. Since then US production has continued to drop (see the table on page 16 or go to our web site for a 40-year data.)

Since then other oil producing regions have peaked and started to decline. The North Sea peaked in 1999 (it only took five years to 2004 for the UK to become an oil importer). Russia appears to have peaked last year.

Hubbert also, in the 50s, predicted that global oil production would peak around 1995 +/- 5 years. But he had limited data on oil fields outside the US (and oil had not even been discovered in Africa or the North Sea back then). NASA scientists Dr Marcel Schoppers and Dr Neil Murphy updated his work using up-to-date information and came up with 2009 plus minus six years (i.e. between 2003 and 2015).

Even though the date for peak oil will only be known in hindsight, it is almost a certainty that it will be within the next 10 years, and given production over the past two years may well be happening right now.

Of course there are many who argue that peak oil is only a theory and that oil production can continue to increase ad infinitum (though that is not the view of this magazine).

And there is the middle ground, which argues that the current supply tightness is the result of 20 years of under-investment in increased production capacity as a result of the low prices between 1984 and 1999. And that over the next few years as much of the investment that is taking place in Nigeria, Cameroun, TChad, Sao Tome, Angola, Equatorial Guinea, other place in Africa, Iraq and across the world will start to come on stream in large quantities and production will once again begin to increase. At Smart Investor we wonder for how long and believe that surely oil cannot be the one thing whose supply is infinite.

It has also not escaped our attention that in the 60s about 500 new oil fields were discovered, about 700 in the 70s, 850 in the 80s, 510 in the 90s and from 2000 to date . . . less than 100. As important as the overall level of production in accounting for prices is, the amount of production that hits the export markets is even more important. In most oil producing nations, internal consumption is also increasing. For instance, Mexico started reducing its exports in April this year, as internal consumption has more than offset any increased production they’ve managed to get this year. This is exactly what has happened in the UK, where internal growth of 2% and production decline of 3% (since 1999) has resulted in its exports drying up and it is even becoming an importer in just a few years. So, the amount of oil available for international trade may decline even faster than production.

Other factors affecting the price of crude include the state of the US dollar. Even though crude has increased from $40 in 2005 to $140 today, in Euros it has only increased from 50 Euros to 90 Euros. Dollar’s weakness is also a factor influencing the price. Indeed, since 2000 the dollar’s weakness has correlated very strongly with oil prices (chart 1 on page 15).

Many of the US politicians, media and Middle East oil barons have blamed the increase in oil prices on speculation. I believe our analysis here should have put that to rest. Indeed, though there has been a significant increase in investors buying oil ETFs (exchange traded funds) and futures, these investors do not hold physical stock of oil and are both buyers and sellers. They sell their futures contracts before they have to take delivery, so they don’t influence the overall demand or supply.

At Smart Investor, looking at supply and demand and the various theories that examined what the future supply might be, we are very bullish that the oil market will remain strong for at least the next three to four years, probably surpassing $200 within the next 12 months. Here in Nigeria $200 oil is cause for both joy and concern. The structure of the Nigerian economy is such that a small percentage of the population (less than 1 million out of 130 million) enjoys up to 70% of the benefit of any increased government revenue and expenditure.

The funds come in to the federation account, shared amongst the various tiers of government, which then award contracts. It is widely speculated that over 50% of the value of government contracts are enjoyed by politicians, civil servants, middle men and contractors, whilst less than 50% goes into the public works that are supposedly of benefit to the people and salaries of ordinary workers.

This money, because it is significantly in excess of the ability of these people to consume, goes into the purchase of assets, primarily property and shares, or is spirited overseas. This of course pushes up asset prices, making them less affordable to ordinary working people.

The high oil prices also drive up the cost of diesel and petrol, though the petrol subsidy should shield the average Nigerian from this. On the positive side (or negative if you are a manufacturer), high dollar earnings should enable the naira to remain stable or even appreciate against the dollar. This should make imports cheaper (the cost of cement is scandalous), holding down inflation. Unfortunately, it can also hurt local manufacturers.

To capitalise on all this, the smart investor will be investing in stocks, specific stocks in companies involved in importation, oil production, construction and finance, and in real estate, which will be buoyed up.