There are so many doomsayers in regards to oil these days. It seems that a lot of people believe that Saudi Arabia is engaged in a massive price war in an effort to punish Iran and/or to bankrupt many U.S. shale producers. I have read many articles and comments suggesting that Saudi Arabia will allow oil to fall to $40 or even much less in order to take out Iran and the shale producers. Some comments I see even suggest that Saudi Arabia won't do anything as long as oil is above $10 per barrel which has been suggested to be the lowest cost of production for some wells. The problem is that even though Saudi Arabia has a low cost of production, it is highly dependent on the price of oil in order to balance its budgets and provide its citizens with social and other programs. That means that even if the Saudis can get oil out of the ground cheap, it is still not possible to balance the government spending budget if prices are too low.
Many other countries like Iran or Venezuela are even more dependent on oil revenues in order to balance budgets. I find the thinking that Saudi Arabia will engage in a never ending price war as completely off-base for a number of reasons. First of all, Saudi Arabia could afford to give oil away for free for a while if it wanted to, and that would be the fastest way to decimate U.S. shale producers or countries like Iran. But that is not going to happen, nor is $20 or $40 oil likely. Saudi Arabia does not have an endless supply of cheap oil and it's not going to pump it out forever at extremely low prices because that is not a smart business decision. I will tell you what else is not a smart business decision and that is allowing oil to drop too far, too fast. If you truly believe that Saudi Arabia is waging an oil price war that will end up with oil at $50 or less, I think that strategy is a fool's game that the Saudis will never implement; here's why:
The risk in taking an oil price war too far is that it could destabilize the entire world economy. If oil were to fall too far or stay very low for any extended period of time, it could lead to an economic collapse in countries like Nigeria, Iran, Venezuela, or even Russia. That could put the world into a serious recession and trigger another severe financial crisis. It is extremely important for the "lifeblood" of the world economy to have some stability because without it, another crisis could arise that would be much more painful than merely cutting production by a million barrels a day or so.
Negative sentiment is extremely high for the oil sector and I believe a number of small cap stocks are poised for a major relief and short covering rally into the end of the year. That is why I am buying stocks like McDermott International (NYSE:MDR) for about $3, which has a strong balance sheet and a $4 billion contract backlog. I am also buying large cap stocks like Chevron (NYSE:CVX) which offers a generous yield. I also believe that the highly negative consensus think on oil is wrong. This is a buying opportunity. Oil is a valuable resource and the Saudis are smart business people who can do the math and realize that a limited production cut is far better than to allow oil to potentially slide to levels that could destabilize the world economy. If oil does not stabilize soon, the chances of an emergency meeting are going to rise according to some experts. Furthermore, oil is already down enough that it will curtail the rapid growth of the U.S. shale industry and it is low enough to keep pressure on Iran. A recent CNBC article details why one industry expert believes an emergency meeting and production cuts could be coming, it states:
Oil was last at $60 a barrel during the financial crisis, and analysts said $50 is now in sight. "That's not out of the question. It's happening faster than I thought it would happen. I was calling for $50 but I was envisioning that happening in February. The odds for an emergency (OPEC) meeting are going up," said John Kilduff, oil analyst at Again Capital.
On December 2, a Saudi Prince stated that his country would cut production if other countries would also participate. This seems to be the first "olive branch" since the OPEC meeting and it appears to be in response to the slide in oil since that meeting took place. It is not in the best long-term interests for the Saudis to destabilize the global economy, or to pump out oil at very low prices. For these reasons, investors should not believe that oil will be allowed to decline much further without a strong response from OPEC.
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Disclosure: The author is long CVX, MDR.
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