Michael Shedlock has a great post on the recent slide on oil prices. Shedlock has been predicting a deflationary scenario as a consequence of the credit bust even when commodities reached all-time record highs earlier in the year. Due to oil’s rapid descent past his $70 target, Shedlock is now predicting possible $50 - $60 oil.
What’s interesting about Shedlock’s call is that he fully acknowledges the possible reality of peak oil but does not think peak oil, alone, is enough to drive prices into the stratosphere irregardless of economic fundamentals. He also asserts that peak oil has already been priced in.
In some ways, I agree with Mish. I have taken some flack for suggesting that energy investors should still demand a margin of safety, peak oil notwithstanding, and not depend solely on rising oil prices. If you look at the Seeking Alpha comments from my analysis of Penn West’s (NYSE:PWE) Q1 2008 results, you’ll see some readers seemed to think that oil was going straight up despite poor company fundamentals, much less broad macro fundamentals. So I do not disregard Mish’s call that oil is headed lower from here.
Where I do disagree is Mish’s assertion that peak oil has been priced into the oil price. Perhaps there are some indications of long-term supply concerns priced into oil, especially as you go further out along the strip but I don’t believe that peak oil has been fully priced into the commodity. If it were, oil prices would have to be higher or possibly, oil would no longer be freely traded in the market (for national security reasons).
Perhaps a useful analogy would be the recent housing bubble. Many market watchers were aware of the housing bubble popping as early as 2005. By mid-2007, the public at large were fully aware of the subprime problem. So was the housing bust and its financial fallout then fully priced in the stock markets? Had the markets fully priced it in by the time Bear Stearns was taken under? When the Feds took over the GSEs? Indymac? Lehman’s bankruptcy? Even now, have the markets fully priced in the fallout from the credit crunch?
My points are twofold: first, peak oil is still not readily accepted as conventional wisdom and second, even if a condition is widely acknowledged, such as the housing bust starting in Feb 2007, it does not ensure that the market has accurately priced it. Keep in mind that US indices hit all-time highs as late as Oct 2007 despite the full knowledge of the bust.
My thoughts on investing in oil: I think both Mish and I would agree that oil prices are headed higher (relative to other asset classes) in the long term. Investors who can afford to ignore the short to medium term fluctuations are being gifted a real opportunity here. Perhaps the hard truth is that America, for its long-term benefit, needs energy prices to remain elevated; otherwise, market participants won’t have the incentive to increase productive capacity, to find new reserves or to develop viable alternatives. This will lead to even harder conditions down the line and possibly even higher prices than would be the case if energy prices were to stay in painful territory now. So if demand truly drops off the cliff and oil heads to $60 or lower, it may lay the foundations for an even more violent move up later down the road.
Keep in mind, investors may have to bear considerable volatility and pain in the meantime. By focusing on energy producers with strong cash flows, low debt levels, manageable political risk and good dividend yields, investors can minimize the turbulence while waiting out for the peak oil situation to slowly play itself out.
Disclosure: Author holds a long position in PWE