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Is an oil price surge looming, and what could it mean for investors?

A closer look at whether the oil price could really hit $100 a barrel, what it could mean for investors, and why oil investors should keep an eye on the FTSE 100.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Investors should prepare for the oil price hitting $100 a barrel

George Trefgarne

During the early stages of the pandemic the oil price turned negative. The American oil benchmark West Texas Intermediate, dropped to minus $40 a barrel.

This incredible event was caused by traders who had agreed to buy oil for delivery in April suddenly finding there was no demand for it as the world went into lockdown. They then had to pay others to take it off their hands and find somewhere to store it.

15 months later we find ourselves in the opposite situation. As the world unlocks, demand for energy, both oil and natural gas, is growing faster than supply. As a consequence, the oil price has risen rapidly since the beginning of the year, by nearly 50%, to over $76 for a barrel of Brent crude. That is the highest since 2018.

Some forecasters even believe the oil price could hit $100 a barrel.

The pace of the global economic recovery – propelled by trillions of dollars of stimulus from governments and central banks – keeps taking forecasters by surprise. All the major forecasters have been upgrading their numbers. For instance, the OECD (Organisation for Economic Co-operation and Development) reckons global economic growth this year will be 5.8%, up from the 4.2% projection it made at the end of last year.

More economic activity means more energy consumption as the world goes back to work. But there are some interesting new trends too. For example, weekday car usage in the UK is now back to pre-pandemic levels, as people prefer to use their car rather than public transport.

The rising oil price also means higher pump prices. The average petrol price is 128.7p per litre, the highest since June 2019, with diesel at 132.4p. When lockdowns were introduced last year they fell to as low as 105p and 112p respectively.

The natural gas price has also gone through the roof, especially in Europe. Prices have hit a 13-year high as Russia limits flows through its Ukraine pipelines and deliveries of liquified natural gas have been lower than usual as China buys up more supply. In the UK, the situation is less critical as we can still rely on the North Sea. Here the price is around 79p per therm, a standardised unit of heat energy. That's about the same level as 2019.

All things being equal, supply should respond to rising prices. However, the oil market is complicated, with a number of political factors at play.

For example, the OPEC cartel of oil producing nations are keen to benefit from higher prices. They have only restored around 40% of the production they shuttered last year. Their representatives meet again in early July to review their production levels.

Iran – among the world's largest producers – is still under effective sanctions after the US withdrew from the nuclear deal, as the Islamic Republic was deemed to be in breach of its limitations. As a result, Iran is effectively unable to export oil. There are hopes that an agreement will be reached with the new US President Biden, but that remains uncertain.

The big US shale oil producers have also been surprisingly reluctant to raise production at their usual pace. Currently, 470 US rigs are active. That is a big increase since last year, but still well below the more than 1000 rigs which were active in 2018.

There are several reasons for this. First, investors are pressurising oil companies to reduce capital expenditure and prioritise renewable energy projects. And second, shale companies don't want to increase their costs only to see the oil price collapse later, as has happened in the past.

Finally, it is worth considering the increasingly important role of renewables, such as wind and solar, in the energy mix. While they are growing fast, they still only represent 5% of world primary energy consumption. That compares to 33% for oil and 24% for natural gas. Percentages are as at December 2019.

With so many market quirks, flaws and political complexities, energy markets are especially prone to speculation by traders. This can drive prices up during times of shortage and down during times of surplus. Unless substantial new production comes on stream fast, prices could remain high and volatile.

George Trefgarne is CEO of Boscobel & Partners, a political consultancy. Hargreaves Lansdown may not share the views of the author.

Investing in a price surge

Nicholas Hyett, Equity Analyst

A resurgent oil price will be a huge relief for all oil & gas producers. If it's sustained, the industry might even lose the status it's picked up as something of an investment pariah (although Environmental, Social and Governance headwinds remain unchanged).

Since the cost of pumping a barrel of oil is largely independent of the oil price, a higher oil price feeds through to higher profits. Crucially for oil groups looking to repair battered balance sheets, the higher oil price also makes any oil fields that are up for sale more valuable – speeding up the pace of reducing debt.

So where could those prepared to take a bullish view on the future of oil prices be looking?

This article isn't personal advice. If you're not sure if an investment is right for you, ask for advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Royal Dutch Shell – still resting on the black stuff even if green is creeping in

From 2025 Royal Dutch Shell expects 35-40% of its capital expenditure to be devoted to lower carbon projects including service stations, renewable energy and hydrogen.

However, even then around 30% of cash flow will be from traditional oil, and a further 45% will be generated from liquid natural gas (LNG) and oil derived chemicals and products. That's based on an assumed oil price of $60 a barrel for 2024 and beyond – some way below where oil is trading at the moment. If prices hold up, or even rise, oil could make up for a far bigger chunk of cash flows.

On top of that, Shell is planning asset sales of around $4bn, helping to reduce net debt from $71.3bn at the end of the first quarter of 2021 to around $65bn. A healthy balance sheet is key to the group's 3.2% prospective dividend yield. An improved outlook for the oil price should help the group achieve a better price for its assets. That will help reach its target debt level quicker, leaving surplus cash which can be reinvested or used for additional returns to shareholders.

It should be said that a mixed hydrocarbon and renewable approach is to be found in most, if not all, oil majors these days. However, we tend to think Shell is more attached to its oil & gas assets than most – and as such has more to gain from a strong oil price.

Of course the reverse is also true. Should the oil price fall, the group will suffer.

Remember no dividend is ever guaranteed, and yields aren't a reliable indicator of what you'll get in the future.

Read our recent article on the relative outlook for BP and Shell

Tullow Oil – a change in an unlucky fortune?

Tullow is an out and out oil stock. It operates mostly in Ghana but has smaller assets across Africa as well as developing a larger field in Kenya.

The group produced 74,900 barrels of oil a day in 2020 at an underlying cash operating cost of $12.10 a barrel. That might sound like a recipe for a healthy profit – after all the oil price has rarely been anywhere near as low as $12.00. However, there's a lot more to business than just operating costs, and non-cash costs (particularly depreciation expenses) are very real.

In 2020 Tullow reported a loss of over $1.2bn, and that follows a $1.7bn loss in 2019. Finance costs reached nearly $300m last year, over 40% of the group's entire operating cash flow. Together with sizeable capital investment required just to keep oil fields running, that means gearing (the oil & gas industry's preferred measure of indebtedness) has been mounting.

Given all the bleak news, you might well ask why the company features in this article? Well it's certainly a risky investment (and should be treated with a high degree of caution). However, it also has a high degree of operational and financial leverage, and that makes its results very sensitive to the oil price.

As we discussed above, a rapid increase in oil prices has the potential to significantly increase the profitability of each barrel pumped (even allowing for a sizeable hedge position at Tullow which locks it into pre-agreed prices on some barrels). Since interest expenses are fixed, that extra gross profit should drop straight through to the bottom line. Analysts are forecasting a fairly rapid increase in profits from a low point this year.

However, investors should bear in mind, and we cannot stress this enough, that leverage can cut both ways. It turbo charges returns when things go well, but can result in terminal problems when things go wrong. Anyone considering an investment in Tullow needs their eyes wide open.

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

FTSE 100 – unwitting oil investors

Of course you don't need to buy individual shares to end up investing in oil companies. And in fact most investors in UK funds are likely to have more invested in oil than they might expect – especially if they own a passive tracker fund.

At the time of writing, oil & gas companies accounted for 12.93% of the FTSE 100 index. That's far more than, say, the US S&P 500 index, where energy accounts for just 2.73%.

Investors wanting to increase how much they have invested in oil & gas should bear that in mind. There's a strong chance they already own more than they suspect.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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