Emerging markets to keep oil price high

by Levi Folk | August 30, 2008

The United States appeared to pull a rabbit out of a hat when second-quarter GDP data was revised higher to 3.3%, but don’t be fooled. It is a sign of strength in economies outside the United States, most notably, the emerging markets; it is not a sign of inherent strength in the United States.

Emerging market economies are maintaining rapid growth and even helping the developed world avoid a deeper recession. They are supportive of oil prices and are creating an opportunity for investing in oil producers with a long-term view.

No doubt many investors’ spirits were lifted and pondered whether the data means that the U.S. economy will avoid recession (it doesn’t), and whether it means the U.S. stock market has bottomed (it hasn’t). The trade gap apparently added 3.1 percentage points to U.S. growth, the most since 1980, according to Bloomberg.com. So, take out trade and growth was essentially flat. A round of thanks is due to the emerging markets.

China jumped to the third spot as a destination for U.S. exports in the first half of this year, ahead of Japan, the world’s second-largest economy. The difference between the two economies is that China’s is growing while Japan’s isn’t. U.S. exports to China increased at a 20% rate over the previous year.

Risks to growth in the United States are clearly to the downside and this is the risk for oil prices. The domestic U.S. economy remains weak, led by anaemic consumer spending. The labour market continues to contract; wages are rising more slowly than inflation; and many Americans are dealing with declining wealth.

Twenty per cent of all U.S. homeowners with mortgages are currently in positions of negative equity. Since the value of their homes is less than the value of their mortgages, there is a very real incentive for these people to walk away from both the asset and the even greater liability.

Futures markets are predicting a further 15% fall in house prices, in addition to the 16% drop on average over the past year. This would raise the proportion of Americans with negative equity to 40% of all mortgage holders, according to Martin Feldstein writing in the Financial Times.

Feldstein warns of a possible negative feedback between falling house prices and defaults that could cause an overshoot in house prices to the downside.

In contrast, retail sales in China are the strongest in more than a decade, rising at a 22% annual rate in July, and this is the opportunity for oil investors. Second quarter GDP growth clocked in at over 10% on an annual rate. Charles Dumas of Lombard Street Research argues that the actual number is closer to 14%.

No matter how you slice it, China’s economy is overheating. It is expected to slow on weaker export growth to the developed world. Economies of Europe and Japan actually contracted in the second quarter of ’08. The impact on China will not be great, however, because net exports accounted for only 16% of China’s GDP growth in 2007, according to CLSA Capital Partner’s Greed and Fear.

But it could provide some relief to the emerging markets including China given the rising inflation across these countries.

So the balance of power for the global economy falls on the side of the emerging economies. If this growth can be sustained, and it very likely will be, it suggests that equity valuation in many of the emerging economies are very compelling. The P/E ratio on the MSCI Emerging Markets Index at 14 at the end of June, is close to its low of 10.8 reached in September, 2001.

It also suggests that oil prices will remain firm and not correct strongly below US$90 per barrel. Demand in the OECD is declining this year as high oil prices and weak economies engendered demand destruction. The International Energy Agency is predicting OECD demand for oil to fall 1.3% this year.

That factor would be devastating to oil prices were it not for strong demand in the non-OECD countries. The IEA is forecasting demand growth in the non-OECD of 1.4 million barrels per day this year and next. China alone accounts for 400,000 of those barrels of daily demand.

Supply is expected to rise over the next year, but investors should look forward to an eventual recovery in the developed world even if it is two years out. Oil prices are likely to remain firm if the emerging world can sustain itself, and many oil stocks are priced for global recession.

Therefore, many companies in the oil sector also offer good value. The oil majors are trading at very low multiples right now and appear to be very safe, if unexciting, bets. Exxon Mobil Corp. (XOM/NYSE), the world’s biggest oil company, is trading at a multiple of 8.5 based on 2008 earnings.

Better bets are Suncor Energy Inc. (SU/TSX), the oil sands operator with long-lived assets, trading at a multiple of 15 based on 2008 earnings and Nexen Inc. (NXY/TSX) producers in both the North Sea and Canada’s oil sands, also well-valued trading on a low seven times multiple of 2008 earnings.