We upgraded our recommendation on the oil & gas sector to “overweight” at the beginning of December. That is, we believe that the sector will outperform the FTSE 350.
The fundamentals for oil demand were much stronger than expected in 2010, and consequently the global inventory position, which still remains above the five-year average, entered 2011 in a much healthier position.
However, the sharp increase in oil prices in the final two weeks of 2010, admittedly on very low volumes, has taken some of the shine from the potential upside in 2011.
For most of 2010, our $79 per barrel forecast for Brent was above the consensus, and the eventual turnout was just over $80. As I write, the 2011 consensus is nearly $98, almost $4 above the year-end figure. I think the oil price may go through the $100 barrier this year and average $96.
With quantitative easing and the continuation of the Bush tax credit stimulating the US economy, American oil demand is set to reverse the recession-induced 5% drop in 2009.
The developing world’s growth rate, especially in China, could slow slightly, but should still account for about two-thirds of the growth in global demand in 2011.
Thus, in 2011, there should be a second year of recovery in demand from the world’s largest consumer. That is, the US, plus continuing growth from developing countries.
On the supply side, the increase in non-Opec supply will be only half of that in 2010, as American production is impacted by the Obama moratorium on offshore drilling. However, this may be offset by strong growth in oil tar sands, Kazakhstan and in sub-salt Brazil.
I also think that gas markets, even in North America, will be better this year. Coal substitution should continue to play a key role and the recent surge in the price of thermal coal, following the floods in Queensland, Australia, could be positive for gas demand.
US natural gas prices should continue to be influenced by rising production from unconventional sources, however, there is likely to be much less support for new output as attractive three-year hedging schemes expire.
A lack of new projects reaching the final investment decision, combined with strong demand from Asia, could see a gradual tightening of supply of LNG. Rising gas and LNG prices are supportive for BG Group, one of my preferred large-cap stocks in the sector.
Rising oil & gas activity is also bullish for the oil service companies, with 2011 being the second year of what I believe will be a four-year cycle.
The sector did well in 2010 despite a muted level of projects reaching “final investment status”, with more short-term brownfield contracts to improve recovery rates and efficiency at existing fields awarded.
I think that both national and international oil companies will focus on offshore activity, particularly deepwater subsea and floating LNG facilities projects, as well as frontier developments. These tend to be more complex in engineering and require specialist management, two key skills associated with Amec, our top pick in the sub-sector.
Finally, 2011 is going to be another tough year for BP in terms of further investigations and examinations of the Macondo accident. I think it will survive the charge of gross negligence and increase its attraction to investors through the resumption of dividend payments and the potential for production growth following the completion of its asset disposal programme.
Mark McCue is a divisional director at investment management and financial planning specialists Brewin Dolphin.
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