History Of The Current Oil Price Crash And Where To Invest

| About: The United (USO)

Summary

We are currently in an oversupplied oil market but things aren't always what they seem.

Investing in the oil market is simple if you follow a couple of key principles.

2016 is going to be a much better year than 2015, despite what you may see on television.

Why OPEC has failed to act to shore up production and fix this issue.

Introduction

If you are a new or experienced oil investor in a popular oil Exchange Traded Fund (ETF) like (NYSEARCA:USO) or (NYSEARCA:OIL), it can be difficult to understand how the price of oil reached its current level and subsequently where to invest. From time to time, an article is published that provides a history lesson for those that have just tuned into what's going on with the price of oil and oil-related investments. I thought it was about time we had another such article.

Price is truth?

Over the past year, I've been long oil via Linn Energy (NASDAQ:LINE) (NASDAQ:LNCO), BreitBurn Energy Partners (NASDAQ:BBEP), Transocean (NYSE:RIG), First Solar (NASDAQ:FSLR), Legacy Reserves (NASDAQ:LGCY), and Mid-Con Energy Partners LP (NASDAQ:MCEP).

If you look at the volatility represented in the chart below, you could be mistaken for thinking it's a chart of a hot technology stock, not the price of WTI Crude oil for the last 18 months.

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Source: Nasdaq.com

To provide some perspective on exactly how big the recent moves in the price of oil have been, this next chart shows the previous 3 years, you can clearly see the difference.

Source: Nasdaq.com

For anyone following financial markets back in 2008, you'll remember crude hitting $140 a barrel. At that time many were calling for even higher prices. Goldman Sachs made their now famous $200 oil claim, and some were even calling for $300.

The chart below shows the price action from 2008 to 2011 with the red lines highlighting the peaks and troughs.

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Source: Nasdaq.com

During 2008, there was a significant drop in world oil demand due to the global financial crisis. OPEC subsequently agreed to cut production by 4.2 million barrels at their meeting in December 2008 and oil producers lived happily afterward with prices trading in the $80 to $100 range until late 2014. However, during the years following 2008, U.S. consumers felt very threatened by $4 gas and what a reliance on overseas oil meant. With the U.S. Presidential election campaigns in full swing, chants of "drill, baby, drill" and "drill, drill, drill" became staples of U.S. Republican Presidential candidates. Even though U.S. President Obama didn't feel like the U.S. could fix the issue alone, he pledged to end the "tyranny of oil" in early 2009. I'll cut a long story short with a chart.

U.S crude oil production:

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Source: EIA

You can see the massive increase in production that was seeded in 2008. Here is the same chart overlaid with the price of WTI:

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Source: Data from EIA.gov

You can clearly see the negative impact that the U.S. production increase had on the price of oil.

OPEC response to the latest glut

Late in 2014, when the oil price really started moving downward, those who remembered the price action in 2008 could be forgiven for assuming that an OPEC production cut would fix the issue and everything would be OK. The conspiracy theorist inside many of us assumes that oil cannot stay low for very long and that the price simply has to go up, if not for any other reason that the big, greedy oil companies will make it happen as they always do. In December of 2014, OPEC somewhat surprised the market by choosing to defend market share at the expense of price.

For those that remember the 70s and 80s, the chart below is a quick reminder of the price action:

Whole articles have been dedicated to this previous glut, but I'll cover the basic differences here. The primary difference between the glut of the 80s and the current glut is that in the 80s there was slumping worldwide oil demand coupled with enormous excess world production capacity. The other key difference between then and now is that this current glut is driven by growth in U.S. shale oil production. There is no historical precedent for the response of shale production to a price slump and we're in uncharted territory.

Saudi Arabia learned many hard lessons during this time with the principal one being that when the price slump is due to excess supply, cutting production leads to cheating and loss of Saudi market share. So why did OPEC cut in 2008? The price crash in 2008/2009 was due to reduced demand not excess supply. Saudi Arabia and other OPEC members fear that if they cut production in the current glut that they will permanently lose market share to higher cost producers, the largest of which is U.S. shale. U.S. shale represents around 50% of current U.S. production and close to 100% of U.S. production growth as depicted below:

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Source: soberlook.com

The fundamental oil story

There is much more to the price of oil than simple supply and demand fundamentals. Many will argue that oil pricing over $100 was an anomaly and that $40 is a more accurate historical average price. This is overly simplistic as the marginal cost (the cost to produce one more barrel) is changing constantly and demand continues to grow. When you hear or read about recent falling worldwide oil demand, it actually has meant that demand is growing but not as fast as expected. This is definitely a little misleading and has confused many casual investors. The charts below illustrate both the inflation-adjusted price for crude as well as world oil demand for the last 35 years:

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Source: inflation.us/oil/

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Source: EIA

Key 2015/2016 events

WTI Crude hit a low of $26 in January of 2016 marking what some think is the bottom. My opinion is that the average sustainable marginal cost of a barrel of oil is around $65 even with all of the so-called technological advances. Oil service costs are artificially low right now because of the oversupply of labor and equipment, but I believe that this won't last. Schlumberger (NYSE:SLB) CEO Paul Kibsgaard agrees stating in a recent energy conference that the efficiency gains that have been claimed in the Shale industry are just the result of temporary price concessions.

Although many say the North American Rig Count number is not useful, it's widely reported and many believe (myself included) that less rigs will eventually mean less production. Looking at the chart below you can see a bump in the rig count number during 2015 when oil briefly hit $60, leading many to believe that $60 represents an absolute price ceiling for some time.

If I had to look back on all of 2015 and pick one event with the most influence, it would be the Joint Comprehensive Plan of Action (JCPOA) also known as the Iran deal brokered by the U.S. Government. When the deal was announced it promised to lift sanctions on Iran, which lead Iran to subsequently announce their intention to add 1 million barrels of oil per day to the market. If you map this event on a chart, you can see it was the end of any 2015 oil recovery and the resumption of pain for oil investors and producers.

Another key predictor of oil production is the amount of capital spent on oil Exploration and Production. Oil producer capital expenditure ((capex)) cuts have been significant in the U.S. with estimated 2016 production falling anywhere from 2% to 18% as evidenced by the charts below:

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What we do know for sure is that U.S. production is dropping. EIA's latest data shows production dropped 83,000 barrels per day month on month. The official data shows 56,000 barrels per day, but there was an adjustment to the January number of 27k thousand barrels per day, which I have added into the February data which is when it was brought to light. These little nuances show how cursory looks at the data can be misleading.

Speculation in oil can significantly affect the price. In a recent interview on CNBC, Michael Rothman from Cornerstone Analytics stated that 5 billion barrels of oil are traded per day in contrast to the 95 million of barrels actually consumed. It's been a tough time to be an oil bull as many famous names in commodities have gotten the price of oil wrong, Andy Hall, Harold Hamm, David Demshur, and Boone Pickens are a few of the renowned bulls that have been proven wrong in 2015. Dennis Gartman has been all over the place with his predictions and I no longer consider him a useful source.

Key Lessons and takeaways

Oil is a commodity and to have accurate data you'd need to track hundreds of producers and traders. If an individual had all the perfect data to form a position, it'd have to be adjusted daily based on new information that's available. The bottom line is that you should not try to predict the price of oil in a given period of time.

My best advice is to pick a direction over a longer time period and find investments that match your view.

Ignore most of what you see on TV about oil. Popular media is looking for a popular story and it appears that many reporters have taken a stance on the direction of oil and appear to favor coverage of that stance. Many experts that come on TV have no interest in helping the general public, they want to influence the price for their own gain. The news also comes in spurts, you'll see a day or even a week where all the news is terrible and it seems like oil is going down, only to then have days or a week where all the news is positive. If you follow all this news you will absolutely buy high and sell low. The best advice I have is to take a position and stick to it unless something materially changes over a longer period of time. Do not make snap judgments based on a bullish or bearish week of news.

Where to invest

As you may have guessed from the article, I am a long-term oil bull. There are currently two investments that I think suit long-term oil bulls very well. My current investment approach is to find companies that can not only sustain $50 oil, but will have significant price appreciation. We all know that Chevron (NYSE:CVX) or Exxon Mobil (NYSE:XOM) are safe bets in this environment, and I recommended both of them for investors with a low risk tolerance. On the other hand, if you have a medium to high risk tolerance, I have two names that I like and am currently long. The first is Legacy Reserves Series B Preferred (LGCYO), you can see my recent article on Legacy here. Legacy Reserves is extremely inexpensive right now despite a decent run-up last week. The second is Mid-Con Energy Partners (NASDAQ:MCEP) which has had a magnificent run already.

One last note, I do not recommend the ETFs USO or OIL for anything but the short term. These investments do not track the price of oil over a longer period and will significantly underperform. You don't necessarily have to understand why they will underperform the physical commodity, just understand that it's a fact that they do. For confirmation, check the chart of USO and compare it to the oil price charts above. This also goes for the leveraged ETFs. These are trading vehicles and are not for those with a longer horizon.

Disclosure: I am/we are long LGCYO, LGCYP, MCEP.

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.

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