A 5-year graph of the FTSE 350 oil & gas sector compared to the Brent oil price shows that share prices have failed to keep up with the re-pricing of this commodity. Indeed, over the last twelve months the oil & gas sector has underperformed the stock market to such an extent that valuations look quite attractive. Rising industry costs and fears of lower realised prices continue to be risks for investors but in the short-term lower than expected non-OPEC output growth and OPEC production cutbacks have heated up oil & gas prices again. Currently, futures markets are pricing oil near to $70/bbl over the next 5 years and longer term demand and supply issues could keep oil prices rising over the long-term.
Oil and gas shares: oil price races ahead
The continued strength in demand for oil has been a surprise. After a 4% surge in 2004, consumption has continued to rise albeit at a slower rate despite high prices. Growth was 1.6% in 2005, 1% in 2006 and is expected to rise by 1.8% in 2007. In response, oil prices have risen strongly over the last five years as shown by the graph but share prices as represented by the FTSE 350 oil & gas sector have not been rerated upwards.
This may reflect worries about the cyclicality of the sector and a fear of a fall in prices as in previous cycles, high prices have lead to both lower demand and substitution. However, recent long-term forecasts for oil and total energy consumption show continuing growth in demand.
Oil and gas shares: Long-term energy demand
In the EIA’s (Energy Information Administration) International Energy Outlook for 2007, it forecasts world energy consumption to grow by 57% over the 2004 to 2030 period or at an average annual rate of 1.8% p.a.. About 50% of the projected increase in global energy demand will be driven by electricity needs and another 20% from transport. Over the forecast period, the fastest rate of growth is expected in coal at an annual rate of 2.2% followed by natural gas at 1.9%, liquids at 1.4% and nuclear at 1.3%. Modelling different global economic growth rates seems to have little overall impact on the upward path in consumption and the price of oil is expected to rise over the period. Nevertheless, there are other issues which are difficult to model and could have a potential impact on demand i.e. firm action on global warming or adequate and secure supplies of energy being available at affordable prices.
Carbon dioxide emissions are expected to increase by almost 60% over the 2004 to 2030 period. Currently, petroleum, natural gas and coal account for about 40%, 20% and 39% of total energy related carbon dioxide emissions. By 2030, the ratios will shift with petroleum declining to 36%, 21% for natural gas and 43% for coal. Unfortunately, at the moment it looks as if there is not enough political momentum to make fast and decisive cutbacks to carbon dioxide emissions. Apart from the US dragging its feet over climate change issues, even the UK and EU are not moving quick enough to implement changes. As a result, fossil fuels are still expected to account for 80% of energy consumption in 2030.
Oil and gas shares: Long-term energy supplies
A lot of attention is focused on demand forecasts but access to energy resources is an area of continuing uncertainty. Oil accounts for 38% of total world energy consumption. Although this is expected to fall to 34% by 2030, petroleum will still represent the largest source of energy. Coal accounts for about 26% of world consumption and it could take a 28% share by 2030. Under EIA’s projections world oil production has to increase by 35 million barrels per day to about 118m barrels per day by 2030. Currently, OPEC supplies 42% of world output with non-OPEC countries at 43% and the Former Soviet Union countries at about 15%. OPEC is expected to meet about two thirds of the required increase in production and continued high oil prices are needed to stimulate non-OPEC liquids production especially unconventional oil projects such as oil sands.
Oil and gas shares: Short-term developments
Last May, oil prices reached about $75/bbl and subsequently trended lower until bottoming at about $50/bbl in January on the back of the mild winter weather. As a result, OPEC agreed to cut its production to support oil prices. Currently, non-OPEC supply growth is being held back by project delays/outages and there have been higher than expected decline rates in mature fields such as the North Sea. In addition, refining capacity has been restricted due to higher levels of maintenance. After a slow start to 2007, demand is expected to increase in most countries on an annual basis but clearly demand growth is higher in Asia, Central and South America and the Middle East. With strong demand from China and India and a pick-up in US economic growth expected in the second half of 2007, it looks as if OPEC needs to raise its output to avoid crude prices rising in Q3 ahead of winter.
Can oil and gas shares catch up?
The graph below shows UK oil & gas sector relative price performance compared to the FTSE All Share Index. Although the oil price has risen from $24/bbl in 2002 to $70/bbl in 2007, oil company share prices have yet to reflect this key value driver. The big oil & gas groups such as Royal Dutch Shell and BP are on a 20% discount to the FTSE All Share in terms of P/E and offer a much higher dividend yield e.g. Royal Dutch Shell’s dividend yield is 4.2% compared to 3% on the FTSE All Share. Brent oil prices averaged $54/bbl in 2005 and $66/bbl in 2006. For Q1/2007, the average was $58/bbl but the current oil price is $68/bbl. At this level and with the prospect of longterm issues conspiring to keep oil prices high, oil & gas shares may yet be re-rated.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley