There is a sense of déjà vu in commodities and none more so than oil. This week crude hit a seven-month high, gushing through the $70 a barrel barrier, with Goldman Sachs forecasting $95 a barrel in 2010. This is the same bank that warned only last summer that oil would strike $200 a barrel.
This bullishness assumes a V-shaped recovery. A double-dip slump is more likely, with this bounce petering-out when the real economy fails to replace the growth provided by receding global stimulus packages. What’s more, speculators are back with a vengeance – but they invest more on hope than fact, given anaemic oil demand, brimming inventories and industry excess capacity.
Even if I’m wrong and crude does surge back to all-time highs of $140, there will be another demand slump. The developed world can’t afford sky-high prices without consumption being hit. This is all bad news for Cairn Energy, the independent oil and gas producer operating largely in the Asian sub-continent.
Cairn Energy (LSE: CNE), rated as OUTPERFORM by RBC Capital
The firm owns a 65% stake in Cairn India (listed in Bombay) and 90% of an exploration business called Capricorn, with assets located around the world, including in Bangladesh, Nepal and Greenland. The majority of the group’s intrinsic worth is stored underground in hydrocarbon reserves in Rajasthan in northern India, which should generate peak output of 175,000 barrels of oil a day by 2011.
A 600km pipeline is being constructed to transport the liquids from the fields to the coastal refineries, but meanwhile 30,000 barrels will be trucked using around 600 road-tankers at an extra cost of $8 a barrel. This is a logistical nightmare and carries extra risk. Even more worrying is that the firm hasn’t yet agreed the price at which it will sell its oil to the government, although an official update is expected shortly. Even with a long-term oil price of $70 a barrel, I would only value Cairn at £20 a share at best – 20% less than today. Worse, if I’m right and the economy turns south again in 2010, taking crude to below $50, the shares could easily drop to £15 or lower.
Another potential problem (especially after the recent Indian elections) arises if the local government decides to renegotiate Cairn India’s lucrative profit share agreements in the same way that Russia did with BP and Shell. Above all, I’m not the only bear. Last week five directors sold over £1m of shares for £24.28 each. Follow their lead and take some chips off the table.
Recommendation: SELL at £25.42
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments