On the road to nowhere, or are we?

The new year brought renewed optimism and confidence for the outlook of the global economic recovery which helped the oil and gas sector to rally following a testing 2010.

However, looking back on the second quarter of 2011, the mood is significantly more subdued and it's clear that we're no longer taking the same sanguine view of the economic situation.

It's no surprise. With the faltering fiscal recovery in Europe and the US, the impact of Japan's Fukishima nuclear disaster on its trading partners, concerns around inflationary pressure in emerging economies and the Eurozone debt crisis, the conveyer-belt of bad news is enough to dent even the most optimistic economist's confidence.

Global power is fuelling demand

In natural resources markets, the picture is far different. China continues to fuel demand for oil and gas with the country's gross domestic product growing 9.3 per cent in Q2 compared with 9.7 per cent in Q1, a relatively stable performance despite contraction in the economy of its second largest trading partner, Japan.

China's widespread motorisation, which I addressed in a previous blog, has slowed through a combination of higher food prices, interest rate rises and higher petrol prices. Growth in car sales reduced to two per cent in the country in the second quarter, down from nine per cent in Q1. While this is a significant drop, it's unlikely to quell China's long-term desire to drive forward, literally and metaphorically.

Half a trillion dollars of investment!

In response to improving sector dynamics, oil and gas operators are re-forecasting their budgets. Barclays Capital, now expects global exploration and production investment to rise 16 per cent to more than half a trillion dollars in 2011, compared to an earlier estimate of 11 per cent in December 2010.

The average increase for major US firms is 18 per cent, reflecting the continued interest in unconventional oil and liquids.

Internationally, the US and European independents flush with new capital are also aggressively bolstering their budgets by an average of 23 per cent. These widespread upward revisions in expenditure confirm the sector's enduring belief that higher commodity prices are here to stay which, in turn, paints a very bright picture for investment in oil and gas services.

State of play

As a consequence of the more subdued near-term economic outlook and the release of 60 million barrels of strategic reserves by International Energy Agency (IEA) member states, oil prices have retreated from the highs recorded at the end of Q2, with Brent trading at $112 /bbl ($128) and WTI at $95/bbl ($112). At the close of the same quarter in 2010, Brent crude traded at $72 and WTI at $69, representing a year-on-year increase of 55 per cent and 37 per cent respectively.

In the US, natural gas prices finished Q2 only fractionally higher at $4.40 compared with $4.32/MMBtu, as the market remains well supplied. Estimates for gas usage growth are moving higher to two per cent from 1.4 per cent, as industrial and power generation use increases. At present, NYMEX futures prices remain below $5/ MMBtu until November 2012, suggesting that higher prices are on their way, but we will have to wait until Q4 2012.

However, social or economic disruption in producing regions, such as Sudan; the ability of OPEC-member states to boost and maintain high production, the rate of global economic growth and, particularly relevant at present, fiscal volatility in the Eurozone, could all have a significant impact on oil prices over the coming months. Watch this space.

Gas is here to stay

The second quarter of 2011 undoubtedly presented a more mixed picture in oil and gas compared to the previous three months. However, it was one where the positives continued to bubble to the surface. While the faltering recovery in Europe and the United States remains a concern, oil prices are above forecast for 2011 and very high on a historical basis. Non-OECD demand is rising and supply disruption concerns remain.

The availability of cheap gas at a time of worries around nuclear power generation is leading to a belief that gas is here to stay — a theme which is likely to resonate throughout the industry further during the rest of the year.

The high oil prices and strong fundamentals for natural gas have led to an increase in exploration and production expenditure across many areas, which sets a very encouraging scene for oil services for the remainder of 2011 and beyond.

This climate is creating even greater need for technologies that will meet the present and future challenges of oil and gas production, creating significant opportunities for specialist upstream investors like us.

So, while we look to the future of the global economy with trepidation, oil and gas operators, service providers and investors in the sector are, in contrast, grasping the silver lining.