Interview with Christian O’Neill – Having fallen sharply earlier in the year, Brent Crude has staged a recovery in recent weeks, rising from 89.61 on 21 June to 106.8 as of 20 July. In terms of spare capacity, the cushion is thin. With the threat of Iran closing the Straits of Hormuz, and the possibility that the US could engage a third round of quantitative easing, there are clear macro risks to cause supply outages and support further upward price pressure.
However, looking at crude from a purely fundamental viewpoint, there seems to be a good match between supply and demand according to Christian O’Neill (pictured), energy analyst with Bloomberg Industries: “On the Iran issue, there is sufficient spare capacity to make up lost production from the embargoes, but should Iran shut the Straits of Hormuz it would definitely affect supply; between 14 and 15 million barrels a day move through there. I think the likelihood of that happening is on the lower end of the scale though.”
Demand has been weakening this year on the back of sluggish global economic growth and in O’Neill’s view investors should have a defensive position within the energy sector. Under normal GDP growth conditions of 3 per cent, incremental oil demand grows at 1.1 to 1.2 million barrels per day. Over the past five years, China alone has accounted for 65 per cent of that demand. Given that the US, Europe and China are muddling along this year, oil demand is well below that trend.
“We think there were a lot of expectations priced into crude as we entered into 2012 which continued to build as we expected a potential conflict in Iran and more quantitative easing. Now, with some of that not playing out, the market has drifted back: inventories are high, demand is weakening and you’ve got high diesel and gasoline prices.
“Therefore, going strictly on fundamentals we think crude prices should be even lower than where they are today.”
O’Neill believes a more defensive position is needed by targeting lower beta companies such as integrated oils whose stock prices have smaller moves to changes in the underlying commodities. “You still have exposure to energy but have lower volatility and leverage than exposure to E&P and Drilling & Service companies.”
Those who were expecting higher oil prices to persist in 2012 have been reliant on fat tail ‘Black Swan’ events, which have yet to materialise. Says O’Neill, “Putting macro risks aside and focusing purely on fundamentals our bias would be that WTI crude could be lower than USD84 before year-end.”
O’Neill notes: “Energy has been a high beta sector in the overall market the past two years, suggesting growth and momentum participants are investing in the space. For the underlying equities to keep attracting these investors and reach new highs, crude oil prices would need to reach new highs as well. This is unlikely absent geopolitical events or fiscal easing.”
Given that energy has been the worst performing sector in the S&P this year – down almost 4 per cent – it is starting to attract initial interest from value investors. That could signal tough times ahead as value investors tend not to look at stocks until they are discounting the marginal cost of crude.
“Until longer-term price discounts emerge, energy could be a tough place to be relative to the market. We’ve had a stiff correction off the peak of the February/March high but stock prices are still not close to the levels that long-term value investors would build larger positions,” says O’Neill.
