When Will Oil Prices Rise? When Saudi Arabia Feels The Pain

by: Vahan Janjigian, CFA

With the rise of Islamic extremism in the Middle East and Daesh (or ISIS, ISIL, IS, or whatever you want to call it) in control of oil fields in Iraq, one of the biggest surprises this year has been the plunge in oil prices. Although the decline actually began during the second half of last year, it picked up steam in 2015. Many analysts, including myself, were convinced that oil would find support somewhere around $60 per barrel. We were wrong. Today, one of the key crude oil benchmarks, West Texas Intermediate, is selling for less than $38 per barrel.

What happened? Basically, it's a story of demand and supply. Too little demand and too much supply. However, I thought lower prices would quickly increase demand and reduce supply. Demand is indeed increasing, but not by enough to soak up all of the supply. That's because contrary to expectations, lower prices have not reduced supply. One thing I didn't count on was how determined some of the major producing nations, especially Saudi Arabia, were to let prices fall.

Many OPEC nations, including Saudi Arabia, the United Arab Emirates, Iraq and Iran, have extremely low marginal costs of production. So they can make a nice profit even if the prices fall well below today's level. However, these countries require much higher prices in order to meet their budgetary commitments. As a result, I was convinced that they would not put up with low prices for long. I expected them to cut production and push the market price of oil back into the $60-80 per barrel range.

Saudi Arabia, however, settled on a surprising strategy. The Saudis decided to keep pumping oil at high levels, knowing that the prices would go much lower. The Saudis are betting that lower prices will drive higher-cost competitors, especially in the U.S., out of business. The thinking is that once much of the competition is gone, the Saudis will have a larger market share and greater control over prices.

For years, OPEC's biggest competitor was Russia. But thanks to new technologies such as fracking, the U.S. is now one of the world's largest oil producers as well. However, the marginal cost of production in the U.S. is much higher than it is in Saudi Arabia. Therefore, any reduction in production is likely to be seen first in the U.S. In fact, this is already happening. For the week ended December 4, crude oil production in the U.S. was 9.16 million barrels, down 4.7% from the peak in June. This isn't much of a decline, given the sharp drop in oil prices. U.S. oil producers are proving to be much more resilient that many analysts expected.

For oil prices to move significantly higher, we need to see sharply lower global production levels. Some companies, such as Chevron (NYSE:CVX), have already announced capital spending cuts, but major oil producing nations, such as Saudi Arabia and Russia, are still holding out. No one wants to be the first to blink.

The U.S., of course, is not just a major producer. It is also the world's largest consumer. Low oil prices hurt U.S. oil companies, but they are a net benefit to the U.S. economy. That's not the case for the economies of Saudi Arabia, Russia and almost every other oil-producing nation. They depend heavily on high oil prices. So how much longer can they hold out? They may not announce it, but once the level of pain gets too much to bear, they will start cutting production. Oil prices could move higher rapidly when that happens.

How can you profit from the eventual rise in oil prices? One way is to buy the iPath S&P Crude Oil Total Return Index ETF (NYSEARCA:OIL). This is an exchange-traded note (ETN) that tries to match the returns available through an unleveraged investment in the West Texas Intermediate (WTI) crude oil futures contract.

Another way is to directly purchase shares of oil production companies, but a more diversified approach is to invest in a fund of such companies. One popular product is the Energy Select Sector SPDR ETF (NYSEARCA:XLE). This exchange-traded fund (ETF) holds 40 stocks and has a gross expense ratio of just 0.14%. However, it isn't as diversified as you might like. More than half the fund is invested in just five holdings, and 31% is invested in just two stocks: Exxon Mobil (NYSE:XOM) and Chevron.

A more diversified approach is to buy the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP). This fund includes many of the same names as the XLE and has a gross expense ratio of 0.35%, but it takes a more equally weighted approach. The top five holdings account for only 10% of XOP.