What goes up, must come down

Draft media release

What goes up, must come down

Alwyn van der Merwe, director of investments at (SPI) goes against the grain, saying that high oil prices are not sustainable and explains just why he thinks so…

Johannesburg, June 19, 2008: The oil price is not sustainable at its current high levels and reserves are simply not as critically low as many believe them to be. This is according to Alwyn van der Merwe, director of investments at Sanlam Private Investments (SPI), who was speaking at a second quarter market review today.

Van der Merwe said that, even though the price of oil had spiraled from $60 to $135 per barrel in the past 12 months, the medium to longer term outlook for the oil price was at significantly lower levels relative to the lofty current price. “Of course, the oil price is currently high because of risk priced in - and justifiably so, based on very low spare capacity - but this is simply not sustainable in the long term.”

Van der Merwe said that one of the key reasons for SPI’s view was that it did not share widespread concerns that conventional reserves were at critically low levels. “Based on estimates by BP we hold the view that global oil resources still have in excess of forty years of production left,” he said in response to the theory that low reserve levels have contributed to increasing prices. In light of this, among other factors, he believes that in the long term the oil price should come down.

Van der Merwe also believes that the strains on current capacity utilization should ease in the next few years as investments on future production in the last five to ten years is expected to come on stream. Oil has also become a less affordable commodity. Oil consumption expressed as a percentage of local GDP, is running at a forty year high – a figure that is not sustainable and could be expected to change future demand patterns. High prices will ultimately change behavior patterns over the longer term. Where possible users will either use less oil or will try to develop alternatives for a commodity with traditionally limited substitutes.

Examining the reasons behind the current price hike, Van der Merwe said one critical factor that drove up the price of oil was the shortage of spare capacity in the oil producing world. If the oil producers do not have spare capacity, market participants will drive the price to much higher levels given the political risks associated with many producers and frequent historic incidents that have disrupted supplies. “There is a big premium in the current oil price based on the perceived risk by the market.

He said these were not the only factors driving the oil price higher. “Many commentators have argued that speculators have contributed to driving up the oil price. Although it may be difficult to quantify the role of speculators, it would be fair to say that some speculative activity added to the high oil price. In addition the cost of production has increased significantly as the inputs in the production process have gone up sharply.

” However these factors were not enough to justify the current price and, according to Van der Merwe, certainly not enough to sustain it. One could argue that these risks or perceived risks are not enough to explain an oil price that jumped from $60 a year ago to the current $135 plus price now, but when you find supply side disruption where capacity is tight, it is understandable that the price will respond aggressively.”


Despite his belief that the price is unsustainably high on the long term, it has become a lottery to forecast over the shorter term. He therefore still remains cautious on the global economic growth outlook due to the significant impact the high oil prices will have on global growth and local disposable income. “Historically, global growth suffered each time there was an oil shock. This time it may be no different,” he said.

“There are serious inflation implications. Locally, the high oil price is partly responsible for the inflation rate that is way outside the official target range of three to six percent.

A combination of lower growth and higher inflation will cause a dilemma for monetary policy makers,” he says. While the oil price remains at these levels, it is tough to argue that the governor of the Reserve Bank, Mr Tito Mboweni, will apply a more accommodative stance when he formulates monetary policy.

The high oil price impacts negatively on the currency. The terms of trade (ratio between import and export prices) is likely to come under pressure and therefore will put further pressure on the South African currency. “It is for that reason that we argue that investors should ensure that their overall portolios are well diversified geographically. The same argument applies to an equity only portfolio. Investors should ensure that they are sufficiently exposed the industrial rand hedge shares (such as Remgro and SA Breweries) that will protect them against a decline in the rand but also against the risks of subdued global economic growth,” he said.
In conclusion, the short term outlook for the oil price remains uncertain. In the longer term perspective the best cure for the current high prices would be high prices. “This means that the high prices will ultimately change behaviour patterns of consumers – and in time, this will eventually drive the oil price down,” he concludes.

Ends

Sanlam Private Investments
Alwyn van der Merwe
Sanlam Private Investments
Tel: 021 9502273
Cell: 0824595791
Email: alwynvdm@spi.sanlam.com
Nuraan Adams
Atmosphere Communications
Tel: 021 469 1566
Cell: 082 3041022
Email: Nuraan@atmosphere.co.za


About Sanlam Private Investments (SPI)
Part of the Sanlam Investment Group, SPI is a private client portfolio management and stockbroking business, serving high net worth individuals, charitable trusts and smaller institutions. With some R50 billion of assets under management, it is the second largest South African private investment manager, with branches in Cape Town, Durban, George, Knysna, Johannesburg, Sandton and Pretoria. For more information, visit www.sanlamprivateinvestments.co.za.