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Investment: black gold
Three years ago when an analyst at Goldman Sachs issued a report claiming that the oil price would reach $100 a barrel within a few years it evoked amused chuckles rather than real interest in his forecast, writes Merryn Somerset Webb
At the time, the CEO of BP was claiming that "it is very likely that oil prices will range in the medium term around an average of $40", and most people agreed with him.
However, prices have been rising ever since Goldman's man made his prediction: in late May this year the oil price hit $135. So when the same analyst reassessed his calculations last month and announced he was raising his target price for oil to $200 there was no chuckling at all – just a discussion about whether that price would be reached in 2008 or 2009.
So what's happened? The answer is that consumption of oil in the emerging world has risen faster and more consistently than most market participants thought possible. China is already the world's second largest consumer of oil and the International Energy Agency (IEA) expects its demand to rise by almost another 5% by the end of this year, regardless of the fast-rising price of crude.
At the same time, supply is tight. OPEC production is running close to or even at full capacity; production growth in Russia is slowing; and in Mexico, Indonesia and Iran, the production of oilis falling.
New exploration and production projects are in the pipeline everywhere, but no really big and accessible new oilfield has been discovered for decades, so it is hard to see how the supply situation might be turned around.
I am not entirely convinced that the $200 level will be reached soon. With the US economy slowing, we can expect consumption there to fall, so even if China continues to grow at speed (unlikely if the USA really stumbles), overall demand is likely to ease a little and that should lead to a fall in prices.
But, given supply constrictions and the new consumption patterns in China and India, it is still unlikely that the oil price will fall back to anything like BP’s 2006 forecast of $40. A range of $80-$100 is more likely.
Making money out of the high oil price shouldn't be too hard. The easiest way in is to buy shares in Royal Dutch Shell. Its profits are a function of the oil price – as long as the price stays high, so will the firm’s profits.
The City, while it appears to accept that a high oil price is here to stay, still doesn't seem to have accepted the second part of the equation. The result? Shell shares are far too cheap: they trade on a price/earnings ratio of only 7.6 times, having seen profits rise 13% in the first quarter of this year (the average for the FTSE 100 is more than 12 times) and pays a reasonable dividend yield of around 3.5%.
* This article first appeared in the July 2008 edition of Saga Magazine. Merryn Somerset Webb is the editor of Moneyweek and writes an investment column every month in Saga Magazine. Merryn's opinions are her own and for general information only. Always seek independent financial advice.
