Small oil producers are a good crude play, says Axa IM

Investing in oil is a good idea in the medium to long term, thanks to growing emerging-market demand and concerns over how it will be met -- and buying into a small- and mid-cap fund is a wise strategy to benefit from rising crude prices. So argues Philippe de Lavalette, director in the equity division and commodity/energy specialist at Axa Investment Managers in Paris.

Demand growth for crude oil is largely non-OECD driven, and that is increasingly the case, de Lavalette told AsianInvestor yesterday during a trip to Hong Kong. The other significant factors affecting the oil price include actions by oil cartel Opec and supply issues, namely the decline rate of current oil fields, he says.

"The medium-term supply/demand picture will remain tight for the foreseeable future," says de Lavalette. "The only things that would affect it would be unforeseen factors, such as if oil were to become obsolete due to the discovery of a new substance to replace it. But that doesn't seem likely any time soon, so oil remains a basic need and there's no immediate plan B."

That means the oil price will be higher in the coming years, he argues; that said, today it is short-term supply and demand that really affects prices.

Demand for -- and therefore the price of -- oil will be increasingly driven by emerging markets, and there are big concerns over whether enough will be produced to supply the growing needs of China and India.

De Lavalette cites the fact that US oil consumption steadily increased from the late 1800s from close to zero barrels per year per person to peak in the 1970s at around 30 bbl/person/year, before stabilising at around 25 bbl/person/year since around 1980. Likewise, Japanese consumption shot up from very low levels around 1950 to peak in the 1970s and stabilise at around 15/bbl/person/year since 1990.

However, countries such as China and India still have very low consumption in comparison, says de Lavalette, and while they may never hit US levels, they will continue growing. China's oil consumption rate is around 7 million bbl a day, as against 19 million bbl/day in the US. Bearing in mind that China's population is more than four times the US's 300 million, that gives a good idea of how much crude could be required.

If one considers that the consensus among major oil companies is that oil production is likely to peak at 95-100 million bbl/day, up from 86 million bbl/day now, China would need all the extra and more just to satisfy its own demand, notes de Lavalette.

"So we clearly have a supply problem," he says. The oil price may fall in the short term, in view of economic concerns from Europe and continuing weakness in large economies worldwide, as it has in the past week, falling from around $85/bbl to $71.37/bbl as of Friday May 14, he adds, but looking ahead it's bound to rise.

Certainly, it wasn't so long ago -- July 11, 2008 to be precise -- that oil hit an all-time high of $147.27/bbl, and predictions of the price reaching anything from $200/bbl to $400/bbl were flying around. In view of the rising demand from China and the like, many would argue such figures are entirely plausible.

In the meantime, until Western demand -- particularly US demand -- picks up and stabilises, the oil price will remain volatile in a range from $65-85/bbl, trading on the news of the day, says de Lavalette. And assuming it stays in that range, Opec is unlikely to intervene -- the organisation has repeatedly said it would like prices to stay in a range of $70-80/bbl.

A good way of playing the oil investment theme is to buy into small- and mid-cap energy companies through a fund, says de Lavalette, as this will provide more diversification than picking individual stocks.

Why smaller companies? For one thing, production by the five biggest majors -- Exxon Mobil, Royal Dutch Shell, BP, Chevron and Total -- has been falling over the past few years, while that of small- and mid-cap oil E&P companies is rising. Hence, while the super majors are safe investments -- offering regular dividends, for example -- their future profit growth profile is not as good as that of the smaller producers. That's because the smaller companies have a better profile in terms of production and reserves.

The problem for the majors, says de Lavalette, is that they are forced to continue looking for new sources of energy, often requiring significant risks and new technologies. And even large discoveries do not have a big impact on the majors' production and reserve profiles.

Another advantage for small-cap producers is that big sources of demand, such as China, can more easily acquire stakes in or control of smaller companies than they can in the majors. In addition, the majors themselves are also natural buyers of the small-caps. Hence, there is strong support for smaller producers, particularly in the short term, in view of substantial amounts of M&A activity that has taken place and is likely to continue.

As a result of these factors, small- and mid-cap producer stocks offer stronger potential returns than the majors (see graph below), says de Lavalette. But at the same time their share prices tend to drop more heavily in times of crisis, when large caps become a place for investors to hide.

Figure: MSCI Small Mid Cap Energy  vs world energy indices vs oil spot price, rebased from December 1999