Oil Prices: Current Low Inventories Already Discounted.

Investors' focus seems to have shifted away from the fear that oil prices will be spiraling downward, as improved technology and access to new geology lower the cost curve. Increasingly, the outlook is that a faster-than-expected decline curve and scarcity will put upward pressure on crude prices while (ironically) costs remain low. Oil prices, which are near five-year highs, appear to support this forecast. However, we believe the pattern of oil prices is best explained by the behavior of inventories. Similar to the argument we have outlined for natural gas prices, logo crude inventories have resulted in high current prices, but do not forecast them. Using U.S. data as a proxy for the world, current inventories are about two days low versus normal. To the extent inventories correct upward—which we foresee will occur, in response to the aggressive production plans by E&P and integrated oil companies — prices will moderate to a level closer to the replacement cost of $18–$19 per barrel. This does not imply that we have changed our belief that rising capital spending will yield less-than-expected supply growth as eroding productivity mutes the gains—but rather that the magnitude of investment should still allow inventories to be replenished. Capital spending in 1995 was sufficient to increase worldwide crude reserves by 2.9%., the fastest rate in five years. We are projecting that capital spending growth will accelerate to 20% in 1996 and be up another 10% in 1997, allowing non-OPEC production growth to stay ahead of the most bullish expectations for overall demand. We expect that falling oil and natural gas prices will erode E&P profits. However, that segment's decline will be offset by gains in refining and chemicals earnings, leaving overall returns for the integrated group about equal to their historical average relative to the S&P 500. Valuation support is also about neutral, leading us to recommend a market-weighting for the group. Among the integrateds, we prefer Unocal, Amerada Hess, and BP for their downstream and cost, cutting exposure. [ABSTRACT FROM AUTHOR]

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