Problems in Iraq bring crude oil back into the limelight

Until recently, the price of crude oil had enjoyed one of its most stable periods, with tensions following the toppling of Gaddafi in 2011 abating and both demand and supply remaining steady in the years following. However, with rise of ISIS in Iraq threatening to push one of the world's biggest oil producers into civil war, the oil price has moved out of its recent trading range and has led to market commentators taking another look at the asset class, both in terms of the oil price itself and oil equities.

So what is the likely impact of current chaos in Iraq to have on the oil price? Well, the consensus seems to be not much. Iraq currently produces around 3 billion barrels per day, which is something in the region of 4% of global usage. However, the area of Iraq most affected by the ISIS onslaught, centred around the Sunni triangle, only accounts for 150 barrels per day of the total. Provided the violence doesn't spread into the Kurdish autonomous region in the north or the area in the south around Basra, the material impact of the uprising should be negligible. Also, Saudi Arabia has spare capacity and should be able to make up the shortfall. That said, should the conflict escalate and destabilise the entire region, including the Arabian peninsula, all previous oil shocks would frankly pale in comparison.

Much has been made of the American shale oil revolution that has brought new supply into the market, but James Waghorn, manager of the Guinness Global Energy fund, thinks supply globally remains tight, and demand is to increase as the emerging markets develop. In short, the long-term picture looks promising but why would you buy into oil today? Well, the answer lies in oil equities.

The oil majors have long been castigated for destroying shareholder value in the pursuit of increasing supply at the expense of profitability. However, having been punished by equity markets, these firms now understand that trend was unsustainable. They are scaling back on less profitable projects, reducing costs and re-positioning towards oil-producing assets. In time, this could lead to increased profitability, which may drive dividend growth and multiple expansion.

In summary, the short-term picture for oil is unclear, but many of the oil majors are trading on attractive valuations and this could potentially provide a potential entry point. Also, the diversification benefits of oil, and its inflation-hedge characteristics, remain as attractive as ever.

By Harry Drsicoll, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Harry's views are his own and do not constitute financial advice.

Published on 30/06/2014