Recent volatility in commodities reflects investor unease that economic growth momentum is peaking. While the short-term outlook for the oil price is highly sensitive to global economic activity and demand from China, the longer-term outlook is more a function of constrained supply and the higher cost of extracting a barrel of ‘black gold’ from increasingly challenging locations. Recent events such as the conflict in Libya, the wider unrest in the Middle East, and the impact of the earthquake and tsunami on Japan, fall into the category of supply-side shocks and only serve to enhance the attractiveness of hydrocarbons. Volatility remains an ever-present feature of commodity markets, so investors should favour the long-term stock market beneficiaries of these commodity pricing themes rather than pure commodity investments, which have no ability to generate income and tend to be much more risky. Oil price resilient even after recent wobble The combined impact of Libyan conflict, unrest in the Middle East, and the earthquake and tsunami in Japan has been equivalent to a supply-side shock for the global economy. Although Saudi Arabia has made up the shortfall from Libyan oil production, the price of Brent crude oil remains over $100 a barrel (12 May), even after the recent wobble in commodity prices. The situation in the Middle East has a clear and present impact on the oil price. Events in Syria have provided the latest alarming news of democratic protestors being fired upon by authorities. While the intensity of unrest varies from state to state and from day to day, the movement retains momentum and further developments seem likely. In Japan, the well-advertised problems at the Fukushima nuclear plant reopened the debate on nuclear power (prompting a change in German power strategy) that strengthens the hand of oil and gas, given that renewable energies remain expensive and as yet lack the required infrastructure and economies of scale. I think companies with attractive oil and natural gas assets, such as Gazprom and BG, stand to benefit. Commodity price growth structural, not cyclical Historically, commodity prices were more predictably cyclical than they have been over the last decade or so. The market is an excellent discounter of the future, however, so we must recognise there has been an underlying shift that has accompanied the last decade of more persistent commodity price strength. Economic growth in China and emerging markets has considerably raised the demand profile for finite natural resources like oil to the point where it is has begun to constrain excess supply. The upswing that we have witnessed in commodities like oil is at least partly explained by an increase in the structural, rather than cyclical, element of commodity pricing. The underlying shift is apparent in the oil industry, which has moved from an ‘exploitation phase’ in the resource to an ‘investment phase’. Proven, easily accessible reserves (the low-hanging fruit) are being steadily depleted and extraction rates are deteriorating. New and expensive projects to access previously less accessible oil reserves are required to meet increased global demand, primarily from industrialising emerging markets. Difficult extraction means higher prices A major part to understanding the outlook for the oil price lies in the cost of extracting an extra barrel of the stuff. In short, this ‘marginal cost of production’ has been rising significantly. The cost of producing a barrel of oil in well-established Middle East fields is as low as $20. However, the cost of eking out a barrel from the oil sands in Canada or from the deep water off the shore of Nigeria is estimated to be anywhere between $70 and $100 a barrel; harsher regulations and stricter safety measures in the wake of the BP oil spill could push up this range further. Over time, the price of oil should approach its marginal cost. If it is lower, producers will simply cut exploration and production to avoid losing money. Significantly, at the current level of oil price (above $100 a barrel of Brent), the major oil companies are able to put much needed capital expenditure to work on projects that would not have been commercial at lower prices. It is revealing to note that despite a significant lag time before they pay off, large projects in more challenging fields are being undertaken, suggesting that industry executives believe the longer-term outlook for the oil price is also positive. Backing oil equipment sector While some of the big recognisable companies will benefit, the part of the industry that is most interesting to me is the oil equipment sector. This is because the firms are particularly sensitive to a higher oil price and greater oil industry investment. The sector includes companies that specialise in certain aspects of oilfield development and offshore drilling. The offshore drilling sector is an area benefitting from a pick-up in oil exploration in spite of the only gradual recommencement of drilling in the Gulf of Mexico. Next big discovery a long way off It is notable that the overwhelming majority of oil production comes from conventional fields discovered prior to 1973. However, in recent years the industry has not hit anything remotely approaching the huge Ghawar field in Saudi Arabia first discovered in 1949 and it seems unlikely to. While there have been a slew of new discoveries off the coast of Brazil in recent years that have strong potential, production comes at a higher marginal cost. The fields are technically difficult in 4km of deepwater and under a further 2km of thick but unstable salt layers. New techniques and vessels are required to drill and operate these fields. Brazilian oil major, Petrobras, has driven up the rates for deepwater drilling in recent years by tying up much of the existing deep-sea rig fleet in long-term contracts. Since shipyards are slow to build additional capacity, this makes the outlook very attractive for many firms in the oil equipment sector, particularly those who specialise in offshore and deepwater drilling, such as Saipem and Transocean. Saipem is the largest oil services company in Europe and I expect subsea construction to account for a significant part of its earnings growth. It invested heavily (around €8 billion) in building the next generation of Ultra Deep Water drilling vessels and I believe it is now well positioned to reap the rewards.

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