Oil markets to barrel forward in 2011

With the global economy performing strongly in 2010, the oil market is showing early signs of tightening; oil supply growth is struggling to keep pace with relatively aggressive production decline rates and demand growth is now robust across many regions. As a result, inventories and OPEC spare capacity - two key indicators of how well supplied the oil market is - are showing signs of trending lower. With energy equities still trading at attractive multiples, there is scope for some positive earnings momentum and upwards earnings revisions. Overall, Robin sees several key factors for investors to watch:

1) Demand for energy is now robust across all regions : Oil demand growth in 2010 was about twice the level estimated at the beginning of last year as growth in demand in the OECD was more buoyant than expected and key non-OECD regions continued to benefit from strong economic growth. Indeed, the third quarter of 2010 marked a new high for global oil demand and the annual growth rate was one of the fastest seen in the last three decades (albeit from a low base). Looking forward, it appears that non-OECD oil demand is likely to overtake OECD demand levels as early as 2013. China remains a key growth sector, with per capita oil consumption circa less than one-fifth of the level of the US, and where there are only 36 vehicles per 1000 population (according to 2008 data). This compares with an US equivalent figure of 842 vehicles per 1000 population [1]

2) The supply issues that drove the oil price up in 2007 are still evident: Many of the world’s oil fields are several decades old and their production levels are declining, leaving the industry struggling to keep up a sustained level of supply. According to industry consultants Wood MacKenzie, the world’s existing oil supply is declining by an estimated 4%-5% per annum. On top of that, the IEA estimates that despite significant investment and some large discoveries in recent years, non-OPEC supply growth is set to rise by just 0.4% p.a. through 2015 (much slower than the 1.3% p.a. average growth achieved over the past decade) [2]

3) The numbers don’t match up: With non-OPEC supply growth estimated to advance by only 0.4% p.a. through 2015 and oil demand estimated to be growing at an annualised rate of 1.3%, the market will have to look to OPEC to make up the difference. This suggests that OPEC spare capacity has now peaked at around 5mb/d and will be gradually worked down over the next few years as the oil market tightens and works off the "hangover" of the slack demand environment caused by the credit crisis, spare capacity and high inventory levels. Notwithstanding the potential for supply shocks, several market analysts are starting to predict that OPEC spare capacity will fall to 2.5mb/d in 2012, levels not seen since the record oil prices in 2007/08.

4) Data is already improving: Whilst many are focusing on political events as the driver of the recent oil price strength, to our thinking there are also more fundamental issues at work. We have already started to see OPEC increasing their production and inventory levels showing signs of ticking lower (in December, OECD forward demand cover fell to 57.5 days, the lowest level in the past two years). We believe that we are firmly in the early stages of an energy upward cycle and yet energy company valuations remain undemanding; it appears the market does not fully appreciate the sector’s earning power. By way of example, if you look at the S&P 500, energy equities make up about 12 per cent of the index, but are expected to deliver around 17 per cent of the earnings this year [3]

Robin comments: "These four key factors clearly demonstrate the exciting dynamics that are happening in the energy sector, and that are likely to drive its performance in 2011.

"Considering this backdrop, investors should carefully consider the sector’s long term potential. In our view, 2011 is shaping up to be the year that energy returns to form, and that will provide significant opportunities with which to invest."