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Why BP plc And Royal Dutch Shell plc’s Fortunes Are More Complex Than You Think

What is the right level for the oil price? How can you value oil?

I guess it’s all about supply and demand. But it’s also about more than that. It is also about trends — trends that begin and trends that end.

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Can we make sense of this complex picture?

So it would easy to predict the oil price? I’m not so sure. Leafing through OPEC’s World Outlook 2014, I’ve found on page 32 that it predicted that in 2015 the average oil price would be $105.7/barrel. But, in mid-2015 the oil price is around $53/barrel. So OPEC, which should know more about hydrocarbons than anyone else, seemingly can’t even look one year into the future.

But this statistic makes all the difference to whether companies like BP (LSE: BP) and Royal Dutch Shell (LSE: RDSB) are buys. So let’s see if we can make sense of this complex picture.

Let’s start with supply. The record high oil prices of the past decade (peaking at $147 a barrel) has caused supply to rise. This means that, alongside the core producers such as Saudi Arabia and Iran, a host of other suppliers have been extracting petroleum.

The high oil price means that countries like Russia and Brazil have been ramping up supply, as even expensive oil found below the ocean floor and in the Arctic is now economically viable.

It has also driven companies to try ever harder and look ever further afield to extract these hydrocarbons. That’s why there has been a shale oil boom in the States, and why the hugely expensive oil sands of Canada have finally produced oil profitably.

This means that the supply of oil has been trending upwards remorsely over the past decade. After all, if oil is worth so much, you want to produce as much as you possibly can.

Not too high, not too low

What will happen when supply increases so rapidly? Well, you would expect the oil price to fall, as consumers bargain down the price of petroleum. And this has broadly been what’s happened. The oil price has tumbled over the past year.

But what about demand? This is where things get complicated. Because the population of the world is still growing, and still getting wealthier. So energy demand is also rising. The crucial question is: how is this demand split between oil, gas, coal, nuclear and renewables?

My honest answer is: I don’t know. But I can see a series of key trends. There are more cars on the road than there has ever been. Almost all of these are petrol- or diesel-powered.

So I think, in the medium term, increasing demand will act as a counter-balance to increasing supply. That’s why I think the picture for oil prices over the next few years is one where they will be not too high, nor too low.

But longer term, fuel efficiency is also improving, and hybrids and electric vehicles have now entered the mainstream. Solar power soon will be the cheapest form of energy. This means that electric vehicles could soon be a lot more popular.

So my view is that BP and Shell do have a future; but they will need to refocus their ambitions and reduce their capital spend. In a way, this counter-balanced view will mean that oil prices, and thus profitability, will be less volatile and more stable. But I still don’t see the oil majors as a place I would like to invest in.

You see, everyone knows that the oil age will eventually draw to a close — but no one knows just how quickly this will happen…

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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.