The price of crude oil has risen 20 per cent in the past three months. This could be bad news for the global economy, but potentially lucrative for long-term investors.
Oil price hike casts pall on growth, but investors take note
As if the global economy didn't have enough problems, it now has to contend with a brutal spike in the price of oil.
In mid-December, a barrel of Brent Crude was trading at about US$104 (Dh382). It recently topped $125, a rise of 20 per cent in just three months, while this week it was hovering at about $123.
That's bad news for the global economic recovery (unless you're a major oil-producing country), but it might be an opportunity for investors.
So what is driving the oil price rise and what does it mean for you?
If you had to name the reason for rising oil prices in a single word, that word would be Iran. Its stand-off with Israel and the US over its nuclear plans has driven regional tension to even greater highs and dragged the oil price with it, says Gaurav Kashyap, the head of the DGCX desk at Alpari ME DMCC.
"Crude oil prices are highly sensitive to supply disruptions and any further escalation will spark a dramatic price shock," Mr Gaurav says.
Some 16 million barrels cross the Strait of Hormuz every single day, including 40 per cent of US crude oil supplies. "If Iran closes the strait, it could push oil prices back to the highs last seen in July 2008, when a barrel of West Texas Intermediate [WTI] hit $145 and Brent Crude hit $147."
However, Mr Kashyap says Iran isn't the only security concern. "There are also potential supply disruptions in politically volatile nations such as Nigeria, Sudan, South Sudan and Syria."
The oil price is vulnerable to even relatively minor disruptions because many producers are now pumping at full capacity. "Despite Libyan output returning to the markets and Saudi pumping at its highest levels in years, global crude inventories remain low. Any increase in crude supply has been absorbed, primarily due to growing emerging-market demand."
Central bankers can also be blamed for the high oil price thanks to their policy of flooding global markets with cheap money in a desperate bid to avert a double-dip recession.
This loose liquidity has leaked into oil and other commodities. "Any additional easing from the US Federal Reserve, European Central Bank [ECB], Bank of England and People's Bank of China will push up commodity prices even further," Mr Kashyap says.
There is a strong correlation between rising oil prices and rising stock markets, says Philippe Waechter, the chief economist at Natixis Asset Management.
Both have been on a bull run since mid-December, when Mario Draghi, the new president of the ECB, launched the long-term refinancing operation (LTRO), which will hand European banks about €1 trillion (Dh4.8tn) of cheap three-year loans in a bid to avert a meltdown. "The ECB operation has increased investors' appetite for risk and this has driven up oil and share prices," Mr Waechter says.
If the global economy does recover this year, the oil price will continue to rise. "If that happens, investors may be interested in buying [shares in] oil exploration companies," he says.
The big worry is that if the oil price rises so quickly, it could sink the tentative US recovery, says Matthew Griffin, a senior research analyst at the BNY Mellon American Fund. "US GDP growth is forecast to be around 2.5 per cent this year, but a significant rise in gasoline prices may slow what has been a rather fragile economic recovery."
Worryingly, every US recession and market crash in the past 50 years has been preceded by oil price volatility, according to research published by oil-price.net. Even the "mysterious" 1987 Black Monday crash, the largest one-day drop in stock market history, followed a price shock sparked by a collapse of the Opec cartel in 1986.
Many analysts also maintain the stock market crash of the autumn of 2008 wasn't triggered by the credit crunch, but by the soaring price of oil in the summer, which saw that all-time Brent Crude price of $147.
Bank of America has calculated that when oil hits $135 a barrel, it starts to inflict serious damage on the global economy.
So will oil keep rising? The experts are split. Angelos Damaskos, who manages the UK-based Junior Oils Trust mutual fund for Capita Financial Managers, which invests in smaller exploration and development oil companies, has been aggressively buying shares in small oil companies on the assumption that it will.
One year ago, just 70 per cent of his fund was invested in equities. Now, he has bullishly ramped that up to 96 per cent. "We started switching into equities in March 2011, when the market presented attractive buying opportunities, and have continued this process," Mr Damaskos says.
"This reflects our confidence in the junior oil company sector for the year ahead. The fund is now well positioned to benefit from the sector's potential for re-rating, which should be supported by increases in the oil price and a strong flow of corporate M&A [mergers and acquisitions] activity."
The high oil price has made smaller oil-producing companies tempting takeover targets. "Large, cash-rich oil companies now find it cheaper to buy listed companies that already control oil reserves than develop new projects themselves," Mr Damaskos says. "Dragon Oil's recent announcement that it is in discussions to acquire Bowleven vindicates our positioning for recovery in the sector."
Other analysts fear oil is entering dangerous territory. Ole Hansen, a specialist in traded futures and commodities with Saxo Bank, says the rally has turned into a "speculative bubble".
"Strong demand, low capacity and Iran have pushed up prices, but hedge funds and speculators are now joining in and this has made the market one-sided," he says. "If Iran stabilises or the global economy slows, there could be a messy correction as investors scramble for the exits."
Investors should bide their time, Mr Hansen says. "I wouldn't jump into oil right now, but if the price fell over the next few months, that would be a great buying opportunity for long-term investors."
Mr Kashyap, of Alpari ME DMCC, has adopted a similar approach. "We prefer buying WTI contracts on any dips, with $103 and below a good entry opportunity."
So how do private investors invest in oil? A popular option is to buy shares in the big oil majors such as BP and Royal Dutch Shell, says Dan Dowding, the chief executive (Middle East & Asia) at IFAs Killik & Co in Dubai. "They are vertically integrated companies, which means they don't just give you exposure to oil, but gas, alternative fuels, refining and power generation as well.
"BP is still trading at a large discount following the Deepwater Horizon oil spill, but it has also benefited from a high oil price and we recommend buying on any dips."
Shell is financially strong and generates plenty of cash. "Its strong balance sheet allows it to invest for growth and return cash to shareholders, typically through dividends. Its 2011 results were a little disappointing, but Shell is a valuable defensive stock and its yield provides a reliable source of income," Mr Dowding says.
Tullow Oil, which has more than 90 exploration and production licences in 22 countries, may be a more exciting way to play the oil price. "Tullow is expected to see a significant ramp-up in production over the next three years as new developments come on stream. It is also vulnerable to bid speculation in a consolidating industry."
But Mr Dowding advises investors to choose their moment to invest carefully. "Tullow Oil's share price has risen strongly over the last six months and we would hold back from purchasing now. Again, wait for a dip."
Over the long term, Mr Dowding is bullish on the oil price. "Global energy demand is projected to increase by around 40 per cent by 2030, of which 80 per cent will be fossil fuels, according to the BP Energy Outlook," he says.
"As existing oilfields run dry, extracting oil from deep below the sea or non-conventional sources such as oil sands will become significantly more expensive. Some of the speculative froth may come out of the market in the short term, but oil prices are set to trade higher than in the past."
If you are brave enough to take a punt on smaller oil companies, Mr Damaskos is currently recommending Amerisur Resources, an oil explorer in Paraguay and Columbia, Caza Oil & Gas, which operates in Texas, Louisiana and New Mexico in the US, and Circle Oil, based in North Africa.
Anybody who invests in smaller oil explorers is moving into dangerous territory. You can make big profits if all goes well, but you can also lose everything if the company strikes water rather than oil. You may prefer to spread your risk by investing in the Junior Oils Trust instead.
Another way to play the oil spike is to invest in Russia, which is the world's largest oil producer and exporter, says Ed Conroy, the co-manager of the HSBC GIF Russia Equity fund.
"Consensus earnings forecasts for Russian companies are based on an oil price of $95 barrel, so there is room for upside if prices stabilise around, say, $122 a barrel. There is also a cushion should the oil price retreat."
JP Morgan Russian Securities is another popular mutual fund that invests in Russia.
Few people expect a return to the days when oil traded at $30 or $40 a barrel. If tension rises in Iran, it could easily beat its peak of $147.
That would be a disaster for the global economy, but great news for speculators.
Most private investors should tread carefully. The oil price could see a short-term correction. It dipped briefly last week following reports that Barack Obama, the US president, and David Cameron, the British prime minister, had discussed releasing reserve stocks to smooth out the oil price. Within days, it was above $125 again.
The price of oil looks set to remain high for years, but with some dips along the way. Those dips may be the best time to invest.