Milestone price boosts investment in sector

Francisco Blanch, director of commodity research at Merrill Lynch International, talks to Tomas Hirst.

Q. The price of crude reached $100 a barrel on January 2. Does this constitute a milestone?

A.

I think it is certainly an important price level. There has been a lot of resistance technically to breaking the $100 a barrel mark and it does represent a milestone.

Few would have thought 10 years ago when it was trading at $10 a barrel that it would reach this mark, but I do not think that it has much more significance than that. Its importance is mainly its psychological value.

Q. Opec (the Organization of the Petroleum Exporting Countries) has suggested the recent surge in oil prices was caused by financial speculators and is not a problem of supply. How far do you agree with this analysis?

A.

I do not agree with that at all. The increase in prices is a function of a tightening supply and demand balance. I do not think that speculators have pushed prices up. In fact I think that the rise in oil prices was caused by the oil industry.

Opec has been cutting supply quite aggressively for the past year and a half or so and if you look at oil production numbers for Opec-10 [those Opec countries that co-operate to influence the price] we have seen a large reduction of over a million barrels a day.

In August 2006 Opec-10 was producing 27.9m barrels a day and they cut that down to 26.6m barrels a day, which in an 85m barrel a day market means you are looking at a reduction in supply of something like 1.5%. So I cannot understand why Opec blames speculators when they have cut down supplies from peak.

Q. Where do you predict the high price of commodities will be felt most severely?

A.

I think that probably the non-oil producing emerging markets are going to be the ones that suffer the most from these prices. Non-oil producing emerging markets where they have a current account deficit, so not so much China, but particularly poor African countries will end up suffering as well as people at the lower end of the income scale in developed countries.

The lower income US or European consumer will undoubtedly be affected by the high oil prices.

Q. What do you believe will be the major factors that will have an impact on oil prices this year?

A.

The major factors that you are going to have this year will be threefold. Firstly, there is a pretty uncertain geopolitical outlook. Although it is a factor almost every year, this year looks to be even more uncertain than in the past.

The year started with problems in Nigeria and now there is an issue with the US and Iranian navies squaring up to each other. Even though it is not clear what happened it does bring to the forefront the fact that there is huge political uncertainty in the market.

The second factor really is the macro-climate uncertainty which, in our view, is probably pretty significant, although we do not think that macroeconomic activity is going to be reduced massively.

We will probably see a bit of a slowdown but we do not believe that it will be on a large scale. It is still a big uncertainty, however, in light of the credit crunch as we do not know how it will affect emerging markets. If it spreads it might cause a reduction in credit in some countries and force a reduction in economic activity in developing markets, which have been driving oil demand.

The third one I would say is ultimately non-Opec supply. In the past few years we have had disappointing non-Opec supply numbers but this year we are expecting relatively supportive non-Opec supply growth.

If the supply growth does not materialise then it would cause trouble in the market. One of the key drivers of the oil prices was caused by global oil production contraction in the third quarter of 2007. We had these contractions because non-Opec supplies really disappointed.

Opec partly reduced their supply to accommodate this new non-Opec supply growth which did not fulfil expectations and drove the entire market into deficit.

Q. Investment into commodities funds was increasingly greater than that of property funds towards the end of last year. Do you think that the trend is likely to continue in 2008?

A.

Yes, I think that is probably true. We are probably going to see a lot of investment in commodities. Certainly we are seeing a big influx into commodities funds now. We could see a lot more in the year as in an inflationary environment real assets provide diversification, which is why gold prices have reached $890 an ounce.

Commodities are a good tool when you have a lot of other things in your portfolio that may not perform as well in an inflationary environment.

Q. In your opinion will high prices of commodities affect the diversification of economies in resource-rich emerging markets?

A.

Historically people argue for the curse of natural resources whereby countries that are wealthy on the back of the natural resource sector tend to stay away from other economic sectors.

More recently, however, we have seen the creation of sovereign wealth funds specifically to deal with allocation of commodities wealth. They have been established in Norway, Singapore and Abu Dhabi and many other oil rich countries have followed suit, including Russia, China and some of the Middle East countries as well.

What we have seen is that those funds are being used increasingly to enter new sectors and invest in new areas, which will yield a high return from a long-term view. I think we might see a bit of a different play-out to what we have seen historically.

Where once in countries that were strong in one commodity you would not see development anywhere else, now you are seeing all these resource rich countries trying to expand aggressively into different sectors.

So the money is being better used, it is being well invested, and certainly the hundreds of billions of dollars some of these funds are managing are helping to boost their economies in areas such as financial expertise and technology.

Thirty years ago most of these profits were being spent or wasted whereas now it is being invested, which makes a huge difference for the long term development of the oil sector.

Q. Do you view it as likely that oil will finish the year over the $100 a barrel mark?

A.

My view is that economic activity is going to accelerate over the next nine to 12 months and we will see prices below $100 a barrel. Our forecast is $78 with the dollar at current levels. It is possible that oil will end the year at more than $100 a barrel but I don’t believe that it is likely.

FRANCISCO BLANCH is director of oil and gas commodity research at Merrill Lynch International. Before joining Merrill Lynch, Blanch was an energy economist in the Commodities Research group at Goldman Sachs. Before working in the financial sector, Blanch taught at Harvard and consulted for the European Commission.