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Investors Chronicle: Oil be damned

Created: 2 August 2007
Written by: Paul Mumford

Just occasionally the markets feel so cyclical you almost want to accuse them of unoriginality. Rewind a year and we were riding out another summer of volatility (albeit the drivers were quite different). Pundits were predicting that oil prices could hit $100/barrel. Now, a recent report from Goldman Sachs suggests the slightly more modest figure of $95 by the end of the year.

Yet second time around, the story is more interesting, as supply and demand data indicates that oil & gas is much more remarkable than the commodities ‘bubble’ so derided by the market’s volatility last year.

Recent International Energy Agency (IEA) data claims that demand will increase by 2 per cent annually, eroding any spare capacity in oil production and producing a supply ‘crunch’ within the next five years. Yet for next year, the IEA predicts an increase in Organisation of the Petroleum Exporting Countries (Opec) production and expansion in refinery capacity.

What is so interesting about this seemingly schizophrenic outlook is that it helps to explain why the oil price can be predicted at $100/barrel and then fall almost $20 that same autumn (as it did last year).

If world economic growth continues, a shortage will be felt. However, it is a delicate case of judging when the fundamentals are likely to tip supply. As of now, the IEA has slapped a 5-year horizon on oil supply unless a slowdown in Gross Domestic Product (GDP) growth provides a breather.

This raises important questions for investors. Let’s take Shell and its robust earnings for the second quarter. These were largely due to Shell’s downstream business, particularly refining. However, Shell’s strategic copybook was blotted. Upstream, its geographical portfolio needs rejuvenation.

Yet it is precisely this exploration and production which is needed to help feed reserves – a fact which makes Big Oil’s juicy share buybacks as frustrating as they are appealing, considering the urgent need to generate future supplies.

For this reason, some of the smaller oil companies are looking tempting, not least as last year’s painful pricking of the commodities bubble has helped to improve quality. Crucially, smaller players have also found it easier to penetrate foreign markets and form meaningful partnerships, which is vital as geopolitical reliance increases. Now, there are many opportunities among the minnows, particularly on the Alternative Investment Market (Aim) where growth potential is huge and a number of companies have well-diversified geographical interests that are already showing promise.

Undoubtedly, there is a bumpy road ahead for this important sector. Speculation in oil futures alone is witnessing a huge level of volatility. Yet for those in it for the long haul, oil may just prove a slick investment.

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ABOUT THE AUTHOR
Paul Mumford is Senior Fund Manager at Cavendish Asset Management, heading the Cavendish Opportunities and Cavendish AIM funds
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http://www.investorschronicle.co.uk/Columnists/GuestColumnists/article/20070802/b80c1aac-4015-11dc-971b-00144f2af8e8/Oil-be-damned.jsp

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