Is It Now Time To Take A Position In Oil?

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Includes: OIL, USO
by: Gary Bourgeault

Summary

Projected increase in demand versus ongoing supply.

Beware of temptation to time the oil market.

Some considerations on what to look for.

Dollar cost averaging versus lump sum investing.

(click to enlarge) source: shale oil investments Click to enlarge

Now that the price of oil has plummeted to under $31 per barrel as I write, it's worth taking a look at whether or not it's getting close to consider seriously investing in the commodity, or continue to wait on the sidelines; including whether to initiate a position or add to a position.

Most of the decision should be based on whether or not investors believe it's at least close to a bottom, or at minimum, a price range that reflects being near to a low.

Since I'm not a believer in timing the market, looking at a price range is the best way to analyze where the price of oil is at. The challenge is we're in uncharted territory. Not because we haven't seen significant price fluctuations in oil before, but because we have never seen it after the emergence of shale oil as a significant supplier.

For that reason we don't know how low the price of oil will go, but more importantly, how long it'll remain in the range it has been trading in recently. There are no signs anyone is willing to cut back on production levels outside of U.S. shale producers.

I'm looking for a sustainable price over $40 per barrel to be the trigger for some shale oil producers. Under these conditions and minus an unexpected geopolitical event, there is no catalyst I see that will cause oil to rebound to that level in 2016.

Demand projections

Most projection for oil demand in 2016 I've seen are for it to climb in the range of 1 million barrels per day to 1.2 million barrels per day. As we're already finding out, demand in the early part of 2016 is lower than expected, and if that continues to be the case going forward, which I think it'll be, we could see the price of oil plummet much further than we already have seen.

Saudi Arabia in particular is basing some of its decision to continue production at high levels on its belief increasing demand will catch up with the current supply levels. It's wrong, and that will play out as such through the next twelve months.

When looking at the two largest markets of the U.S. and China, my expectations are they will both have demand for oil fall in 2016, or at best remain close to current levels. Even if demand in the U.S. were to suddenly surge, it has months of inventory to work through before it would make an impact on the price of oil and rebalancing.

None of this includes the fact Iran will be bringing up to 1 million more barrels of oil per day into the market by the end of 2016. It wants to reach half of that amount over the first several months after sanctions are removed. Only the retaining of sanctions would remove this supply to the market.

There are some that believe Iran can't fulfill its desired production levels. But that's only conjecture that has yet to be proven. Even if it only reached about 700 to 800 thousand barrels more a day, it would have a strong impact on the price of oil.

Several ideas to consider

Under these market conditions and the accompanying volatility and lack of visibility, there are a few things I'm looking at to determine the best places to put money for oil investment.

The most obvious and easiest to identify is refiners, who will get paid what they ask for no matter what the price of oil is. With few refiners in the U.S. and supply still pretty solid, this segment of the oil industry should remain strong for some time. Exposure to refineries based in the U.S. should be a profitable holding over the long term.

Beyond that obvious play is what I consider more interesting and potentially lucrative, and that is in larger energy companies that have the capital and patience to wait out those under pressure from the low oil prices in order to buy some terrific assets at bargain prices. Those identifying these probable plays will generate some quality gains - near term and in the future.

This could include acquiring a company itself, or more probable, buying quality assets at a bankruptcy or sale where a company has to divest of holdings in order to raise capital. One way to identify these early would be to go over the balance sheet, credit rating, and what could be sold to meet existing requirements and have some capital left over to provide a cushion to ride out the low-price environment. In other words, lack of access to capital is the key element to research first.

That's on the sell side. On the buy side, meaning the companies with the capital to make the acquisitions, I would look for probable available assets close to existing holdings.

Even though some of the larger companies have plenty of capital on hand, they still aren't totally sure concerning the longevity of this decline in the price of oil, so aren't, in my opinion, going to buy up assets long distances from something they already have a play in. They would probably make an exception for an extraordinary asset, but they would be few and far between if they were to come on the market.

Existing infrastructure if looking at buying an entire company would be another consideration.

A low price for the asset and decent costs associated with operating it over time is what I would look for. The assumption is the price of oil will remain low for years, and no company is going to put themselves at risk more than they are now to obtain a quality asset or company. There should be plenty of chances to find these types of assets in the months ahead.

Best investment strategy

Retail investors shouldn't invest in oil companies in a lump sum in my opinion, unless you're truly and expert and know what you're doing. Even then I would be more cautious than normal because of the uncertainty and volatility of the market and the price of oil.

Institutional investors, for the most part, tend to invest in lump sums, or at least in large amounts of money at a time. This is one of the reason many hedge funds get slaughtered year after year, as they usually go all in on an investment over a short period of time. There is more of a market timing mentality with hedge funds; something retail investors should run away from.

That's why if investors want to get into oil, it should be done using dollar cost averaging. For those that don't know what that is, it simply means investing at pre-determined intervals. Usually it's done on a monthly basis, although it's not as important as being consistent with the strategy, while using close to the same amount of capital each time.

To employ that investing strategy there has to be a commitment to going through with it. That means you've got to believe the price of oil will rise over time. In the case of heavy refinery exposure, there would have to be the belief demand will remain in place.

No matter how the investment is made though, I'm still concerned about the length of time it'll take for oil to reverse direction in a sustainable manner. For that reason there would have to be the understanding this will be a long-term holding added to month after month. There is the very real possibility if investors were to get in now, they could take a heavy hit in the short term. That's why this isn't something that should be considered being sold in the near term.

Conclusion

As already mentioned, if you're considering investing in oil soon, you've got to be committed. No one has any idea if we're even close to a bottom on prices yet. My belief is barring a decision to cut back on production by OPEC, there is nothing to stop oil from falling further.

Are we at a bottom? I have no idea. Will the price of oil fall below $20? No one knows. Could it? Absolutely! Would it be a disaster if an investor were to start taking a position at this time? Not if you're going to stay in for the long haul.

I know some investors don't like the idea of taking a long position like that. If that's you, I wouldn't put a penny into oil.

My thought is we're approaching a price range that is getting more interesting. That said, if oil does drop a lot further it would without a doubt, in my mind, take months to return to current levels, let alone start moving in a upward trajectory.

What investors have to decide is the risk/reward factor. If you know your companies well and you see some strong possibilities for taking actions, the reward will be worth the risk.

To me, the safest, and probably best bet, would be to go with the larger oil companies which are looking for some quality assets that could add to their revenue and earnings for years into the future. There would be more money to be made with a smaller company being acquired, but that includes more risk and less certainty.

Those with refinery exposure should do well, but the lower risk means less reward. Yet there are still some bargains out there if you prefer to go that route, which won't be affected as much by the price of oil either way. Finding an value not identified by most other investors is the key there. I would be more apt to invest a larger sum under that scenario, than I would with producers and suppliers.

My conviction is the price of oil could go either way, and if a position is taken now, it could take months, or even as long as a year to get back to where the price is today, if it goes south. This is why dollar cost averaging, in my opinion, is the best way to approach oil investing, if you're serious about taking a position soon.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.