Is now the time to buy oil? The case for an Oil Investment Opportunity

Is now the time to buy oil? The case for an Oil Investment Opportunity

The price of oil has fallen dramatically over 2015 and into 2016, having dipped at certain times below $30 a barrel. For value investors, this begs the question – is it time to buy? Is there an oil investment opportunity here?

First – what on earth happened to the price of oil?

At the end of 2014, the EIA, a US government statistical and forecast office, forecasted prices of around $78 per barrel in 2015. They were spectacularly wrong. Oil has essentially been hit by a perfect storm:

  • Chinese growth has been decelerating for several years now, reducing demand for many commodities, including oil. Europe, also a big consumer, has also underperformed growth forecasts.
  • US and Canadian oil and gas production was boosted by widespread investment in fracking (pumping water, chemicals or even explosives into mature wells to break up the rock and make the remaining oil accessible) and shale oil and gas extraction.
  • OPEC, the Saudi-led group of countries that control a large portion of global oil reserves and production, which has historically sought to keep prices high by restricting production, has recently shifted its policy, allowing for higher production.
  • More recently, as the US lifted sanctions and embargos on Iran, the perspective of more supply from this potentially large oil producer, which had until now been shut out from western markets, also put pressure on prices.
  • As oil supply exceeds demand, traders and speculators buy the excess oil cheap, store it and hope to sell at higher prices in the future. This helps soak up some of the excess supply. However, there is only so much oil storage capacity available – so as global oil stocks approach their limit, the oil glut is aggravated.

But if prices are so low, why is everybody producing so much?

First, exploration investments are made years in advance – and the larger they are, the further in advance they are made. So much of the capacity today was built when prices were sky-high, which attracted massive investment. And once the investments are in place, even if prices fall it is often an optimal decision for producers to forget their sunk-costs and keep pumping

Counterintuitively, as prices decline, some companies actually seek to pump even faster, in an attempt to produce enough oil to cover their fixed costs and debt payments. Of course, in aggregate, this drives the price lower and lower.

Specifically, in the case of OPEC, there are several theories to explain why this time they chose not to cut their production. Some argue that OPEC is seeking to keep prices temporarily lower than the cost of their competitors in other markets, thereby forcing them into bankruptcy. Others point to the expensive social policies that these countries have set up and financed with their oil, and which they are not keen to cut amidst fears of political unrest.

In addition to individual company decisions and OPEC policy, geopolitics is also playing a role here, as several producers are financing military action. Saudi Arabia is in Syria and Yemen, and it and Iran are also likely to jockey for regional influence moving forward. Russia is in Ukraine and also in Syria. Iraq is paying for its post-war recovery. And finally, ISIS and its opponents are scrambling for control of Syrian and Iraqi oilfields. This situation is especially curious as, historically, tension in the Middle East has usually led to oil spikes rather than drops.

Could this be an oil investment opportunity?

Quite possibly:

  • Profit margins are already quite low even for low-cost producers in the Middle East.
  • Indebted and high-cost producers can only keep going so long before giving up.
  • At current prices, new exploration is not attractive. As oil wells dry up over time, if there is no new investment, supply must fall and prices must rise eventually.
  • Middle East tensions could suddenly flare up to the point where they disrupt supply.
  • Low prices drive increases in demand: the US auto industry has once again seen a stronger preference for larger cars, which were less in favour when petrol prices were high.

So the arguments for a long-term oil investment opportunity are numerous. Of course, the question is ‘When will this all happen?’. Nobody had expected that producers would produce so much at such low prices during the past year, so they could well surprise us again.

The EIA expects oil supply to outpace demand for at least another 1-2 years, and some of the factors that drive the increases work on something more like a 5-year horizon. For those with a long-term view and willing to withstand fairly severe price swings, there may well be an important oil investment opportunity to consider. How to bet on this opportunity requires some care – while some oil companies and assets will benefit in the long term, others are likely to suffer and even collapse, and it may be advisable to rely on the support of a specialist to invest.


CHRIS LAND, FINANCIAL ADVISOR

Chris has 9 years’ experience as a UK pension specialist and licensed financial advisor. He specialises in helping clients make balanced financial decisions to grow their personal wealth.

Chris is licensed with Globaleye, an award-winning international financial advisory firm established in 1999, with 10 offices and 15,000 clients worldwide.


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