Oil; it's all over the news, in papers, and it's a topic of conversation even between people who wouldn't know a Sweet from a Sour.
Below, I will present a series of arguments (with counter-arguments where suitable), such that the reader should be able to form their own balanced view on this potentially lucrative opportunity.
First, lets see the damage:
This is quite evidently a large and sustained decline in Oil price (here we are looking at WTI specifically).
The two main questions you should be asking are:
How much lower can prices go?
How long before prices will begin heading upwards?
Whilst I cannot give you either in explicit form with confidence (anyone who can is blatantly lying!), what I can do is run you through the factors which I consider build up the bigger picture.
I am aiming to build a picture which should shed light on where we are likely to head in the future. Whilst I can have relative confidence in the direction, the timing is a totally different beast, and therefore I shall instead discuss varying strategies to approach it with.
History does not repeat but it does rhyme - Joseph Anthony
In the chart above (please note logarithmic axes), I have plotted historical prices of oil (WTI). We see that oil has been below $30bbl for the most part of 1991 - 2004. Whilst this may strongly support the bearish view of increasingly low and sustained prices in oil, I must draw your attention to the blue line. The blue line represents global GDP, which has been upwards trending for the most part since 1991, apart from the 08' subprime crisis. I believe this implicitly paints a portrait of a world requiring increasingly large quantities of energy, but I will tread carefully and not claim this shows a 'fair price' of oil (which it most certainly doesn't).
What I am taking from this illustration is that so long as the world continues to grow and develop the core demand for energy will remain.
This is by no means a watertight argument, and its horizon is far too long term for the active investor!
We turn now to what the price of oil means for those who are actively pumping it out of the ground and putting it in these barrels:
It is very evident from this chart, as it is also made clear in the news, that most countries are feeling the squeeze as their major economic output is now costing them. When will the pain be too much and cause countries to cut back output, and how low is too low for the majority?
Not an easy question as these figures are shaky in construction (you can read more about this here). It has been shown that these figures are overestimating the breakeven cost, the most definitive case of that has been with Russia. Whilst analysts quoted $100bbl as a breakeven for Russia, oil revenues were seeing little effects despite ongoing oil price plunges, leaving Moscow in a better than expected condition.
Despite the lack of clarity surrounding these figures, I will argue that a sustained price of oil around or very close to marginal cost of production will cause severe fiscal stress. Lets not forget OPEC ringleader Saudi Arabia with its $98bbl requirements to balance its budget - last I heard they were raising the price of water by 50% to help cope.
The potential 'whiplash'
One very worrying aspect of the whole oil price decline is the lack of appreciation for some longer term factors, most importantly investment. Various big names have been canceling multi-billion dollar projects off the back of the price decline, general oil and gas sector investment has plummeted and continues to do so. Whilst stockpiles build and investment is cut, the potential reversal grows disproportionately. You simply cannot 'catch-up' with the research or dig wells fast enough if a demand led price vacuum emerges.
Whilst everyone is panicking over the low prices, with projects being abandoned and speculators selling, oil is still being used by most of the globe in one form or another - don't forget that.
Short - Medium term factors
Looking to the near future I foresee two major factors, which could (and should) indeed drive prices lower:
Lifting of Iran's sanctions
Seasonal energy demand
Iran has had its Oil and financial sanctions lifted the previous week, which has played a part in the story that has lead to $27bbl oil. With the fourth largest oil reserves, and intentions to pump out in excess of 3.8m barrels of oil, this is no joke to a market in chronic supply.
Moving onto seasonal energy demands: Oil sees a cyclical demand which varies by time of the year, with storages typically building over the summer and then depleting in the winter. Although the chart below is old data, the shape of the curve is what I'm looking to highlight.
Turning to the latest US Crude oil stocks report we see the recipe for a perfect storm. Not forgetting the contribution of Iran!
Whilst current inventories stand at record high levels, we are on the run up to summer 2016 where seasonality suggests a build on existing inventories.
Please note: the shaded region represents a historical range over 5 years, the upper edge of the shading in Mar 16 - Jun 16 has been caused by the weekly reading from Mar 15 - Jun 16. Whilst I am not expecting a build of the most recent build's magnitude, I am still expecting new 5 year highs.
So why am I still considering this an opportunity?
My simple reasoning is that the various factors which I have mentioned are 'priced in'. Retail and institutional investors who are holding assets either directly or indirectly affected by oil prices are making adjustments for this. It was declared back in 2015 roughly when Iran would have sanctions lifted, and seasonal energy demand is no surprise.
Investors on a whole are risk averse; we are willing to pay great premiums on protection against the unknown. My argument is that prices will more often than not reflect the worst case if the situation is an ongoing saga of gloom and doom (aka the oil market).
Events we can't price in (to an extent) are things like unexpected weather, e.g. the US blizzard on the East Coast, and war / terrorism. When any factors not priced in crop up, and similarly there is a change of tone in reported news, there is typically a knee jerk reaction upwards.
How to get involved?
Strategies vary from short term option plays on volatility through to long term equity holdings on the back of structural changes in the oil and gas industry. The decision rests entirely on the reader's risk tolerance.
For those who have low risk tolerance, I would consider a long-short equity play. I would look to have a long exposure to energy intensive industries benefiting from low oil prices such as the industrial sector (VIS). I would also have a short exposure to a basket of the 'old energy giants', such as BP (NYSE:BP), Shell (NYSE:RDS.A) and Exxon (NYSE:XOM), who have begun losing weight during the decline in oil prices, and damages are only just emerging.
For the more adventurous investor, utilising options, CFD's or Spreadbetting to garner leverage may be an idea, looking to take profit over a shorter term price recovery. I have a particular bias toward (buying) options, as they give the investor a limited downside and 'time' to let their trade mature. One could buy (NYSEARCA:OIL) or if not seeking to use margin in order to leverage in their trading account could instead use, for example, a leveraged ETF like (NYSEARCA:UWTI).
To quickly summarize:
Markets are undoubtedly 'oversold', but to what extent is questionable: prices can just as easily head nearer $20bbl as they could $40bbl in the next few months
Considerable financial stresses remain on the oil producing economies, a sustained low price will eventually break the camels back
Negative factors have mostly been priced into oil, and so any change of tone from the market should see a considerable recovery in prices
Investors must cut through the macro noise shrouding the investment / trading decision and make a call
Utilising options will give an investor the ability to purchase at their desired price with leverage on maturity if Oil has indeed risen in price, otherwise their max loss is fixed.
Remember, whatever trade you end up placing, know your risk. Oil trading can be sticky business!
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in OIL over 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.
