LONG TERM OIL PRICES REAL AND NOMINAL

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1 30 June 2008 WHERE TO THE OIL PRICE? We have received many queries about the soaring price of crude oil. In this quarter s communication we analyse some of the issues around the price movements and possible outcomes. History Lessons First some oil price history. The price of crude quadrupled in 1973 after OPEC countries refused to deliver oil as a protest against Western Government s support of Israel. A further price shock followed in 1979 after the Iranian revolution caused supply failures. These oil shocks resulted in fuel shortages, long queues at petrol stations and stagflation for the global economy. During the eighties and nineties oil flowed freely again, to the point of over supply and prices fell to below $10 per barrel from a peak of $40 per barrel. LONG TERM OIL PRICES REAL AND NOMINAL The oil exploration and service industries shrank as the incentive to produce more oil was simply not there. Eventually the lack of new oil field development caught up with steady growth in demand and in recent years prices have been strong, surging to all time nominal highs.

2 OIL PRICE BRENT CRUDE ($139.80) The high oil price has been of great concern to investors and consumers and has been partly responsible for accelerating inflation. Some of the possible drivers behind the price boom are discussed below. Growth in China and Japan has been very strong and while demand in much of the world has been stagnant, the emerging Asian giants have kept global demand growing. China makes up about 10% of global oil demand. Peak Oil Theory forecasts that in 2018 the planet will hit the peak of oil production, which will then steadily decline until reserves become exhausted. Currently many of the major producing fields are old. Some, such as those in England s North Sea will become exhausted relatively soon, without much new capacity coming on to replace them. It does however seem difficult to understand why prices should be high today due to a future shortage when there is no stockpiling in evidence. Oil Price Subsidies are a significant factor in shielding some countries consumers from soaring prices. Although China has recently raised petrol prices by 14%, they remain 25% lower than in the US, which has much lower prices than Europe. Indonesia recently shelved its subsidies when the cost rose to 4% of GDP. China, with its large budget surplus, can probably hold out longer. Other countries have helped ease the impact of higher prices by cutting taxes on fuel. Supply Disruptions, including the invasion of Iraq, unrest in the oil producing provinces of Nigeria, hurricanes and pipeline breakdowns have all contributed to concerns about a potential short term supply disruption and have pushed up prices. Hermes Asset Management (Pty) Ltd Page 2

3 The Weak US Dollar has contributed to the strength of the dollar oil price as producers have sought to keep the value of oil constant in other currencies. While the correlation is strong, US Dollar weakness cannot account for all of the oil price s move OIL BRENT CRUDE IPE (139.81) USA US$ / EURO (1.5793) Derivatives allow investors to buy or sell oil without actually purchasing crude. These markets have existed for many years, with producers and users being key participants. Recently there has been a massive increase in investment activity in these instruments, leading some analysts to believe that this growing paper demand could be leaking into the physical market. This is a complicated and contentious issue and a full analysis is beyond the scope of this article. Exchange Traded Funds (ETF s) are another avenue for investors seeking exposure to oil. These funds could buy physical oil which would take supply off the market, or buy derivatives, where the effect is more contentious. ETF s can have the impact of taking supply out of a rising market and adding supply to a falling one. They introduce buyers who have no price limit and sellers who have no cost of production into the supply demand equation. SA s platinum producers have voiced concerns about the introduction of platinum ETF s. While the impact of these instruments might be debatable there is no question that they proliferate and become popular when prices are going up, and certainly add to the froth in the market. The wrong kind of oil is in surplus. Most of the world s petroleum refining capacity is designed to process sweet crude, which is in short supply. Sour crude is relatively freely available but only some refineries can utilise it. Hermes Asset Management (Pty) Ltd Page 3

4 Supply and Demand Determines Prices So those are some of the factors but what actually determines the price. Economics teaches us that while there are many complicating factors, ultimately prices settle when there is a balance of supply and demand. The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The graph depicts an increase in demand from D1 to D2, along with a consequent increase in price and quantity Q sold of the product. Source: Wikipedia When demand increases in commodity markets, prices increase as buyers compete in order to meet their needs until suppliers increase production. Eventually the increased production will cause prices to settle or even fall. Geopolitics Oil market supply and demand is rather complex, but the principles remain the same. Most of the world s oil is produced in volatile regions or countries. Weather can also disrupt both demand and supply. So while the base price of oil is about $40, it usually trades at a premium due to ongoing concerns about the possibility of weather or politics affecting supplies. There is also almost certainly a significant speculative premium. Some users might be inclined to buy oil at high prices simply due to fear that prices might move even higher. A speculative premium could explain much of the gap between current high prices and the cost of production. Hermes Asset Management (Pty) Ltd Page 4

5 The market is trying to adjust Currently there is a huge incentive to develop new sources of crude oil or to find alternatives. Sasol, as an example, needs oil above $40 per barrel to justify new coal-to-liquids projects and is looking at expanding its existing capacity. The cost of renting an offshore oil exploration rig has doubled in 18 months to over a half a million dollars per day as companies step up exploration work. Oil producers are also looking at ways of improving the efficiency of extraction to increase supply from existing sources. Alternative energy sources become more viable with oil prices at around $140 per barrel and are receiving a great deal of attention. Consumers are also changing their behaviour. Oil consumption in the US is declining, for the first time in many years and globally consumers are seeking out fuel efficient cars. How long it will take to see a benefit from any of these efforts is uncertain. But over time there should be impacts on both supply and demand leading to lower or at worst, stable prices. What Goes Up Must Come Down History is against the high oil price. Almost all commodities that run up steeply eventually surrender the majority of their gains. As far as investment in physical commodities is concerned, a look at the first chart shows that oil will only recently have exceeded the inflation adjusted high it reached in A holder of oil has seen capital depreciation in real terms over a 28 year period. Sasol Hermes Asset Management was a holder of Sasol until late March of this year. At that time the valuation reached historically high levels and could only be justified by speculating that oil prices would continue to make and maintain new highs. We remain convinced that our decision will prove to be correct. Contact Philip Thompson Arthur Karas Bill McAdam Telephone: Facsimile: contact@hermes.co.za Web: Hermes Asset Management (Pty) Ltd Page 5

6 Hermes Management Company was awarded Best Smaller Group over 1 Year at the S&P Fund Awards for st Floor, ICR House Alphen Office Park Constantia Main Rd Constantia 7806 Hermes Asset Management (Pty Ltd) is an Authorised Financial Services Provider. FSP No Reg no. 2004/002377/07 Hermes Asset Management (Pty) Ltd does not take any responsibility for any portfolio actions that readers may take on the basis of this document. Collective Investment Schemes in Securities (unit trusts) are generally medium to long-term investments. The value of participatory interests (units) may go down as well as up and past performance is not necessarily a guide to the future. Unit trusts are traded at ruling prices and can engage in scrip lending and borrowing. Different classes of units may apply to these portfolios and are subject to different fees and charges. Unit trust prices are calculated on a net asset value basis, which is the total value of all assets in the portfolio including any income accruals and less any permissible deductions (brokerage, UST, VAT, auditor s fees, bank charges, trustee and custodian fees, and the annual management fee) from the portfolio, divided by the number of units in issue. A schedule of fees, charges, and maximum commissions is available on request. Hermes portfolios are valued daily at 3pm. Instructions must reach Hermes Management Company (Pty) Ltd before 2pm to ensure sameday value. The funds may borrow up to 10% of the value of the portfolio to bridge insufficient liquidity. The Hermes Equity Fund Class A has an annual Total Expense Ratio (TER) of 1.18%. For the period from 1 April 2007 to 31 March % of the average Net Asset Value of the portfolio were incurred as charges, levies and fees. The Hermes Flexible Fund Class A has an annual Total Expense Ratio (TER) of 1.4%. For the period from 1 April 2007 to 31 March 2008, 1.4% of the average Net Asset Value of the portfolio were incurred as charges, levies and fees. A higher TER ratio does not necessarily imply a poor return, nor does a low TER imply a good return. The current TER can not be regarded as an indication of future TER s. Hermes Asset Management (Pty) Ltd Page 6