This week we take a look at whether investing in oil could be appropriate and timely for private investors.
What is the reason for the dramatic drop in oil prices?
There are two simple answers:
- The dynamics of supply and demand have changed.
- The markets are overreacting
Let’s explore both.
Supply of oil has increased dramatically with better technology making ever more remote oil drilling economically feasible such as the Artic, Brazil’s pre-salt and Canada’s tar sands. We drill deeper, further and more efficiently. The oil industry has been able to convert heavy fuel from tar sands into useable oil at an attractive price when oil was still trading above USD 100/barrel. As a result, the US has turned from the largest importer of oil to a net exporter of the commodity in 2015.
Last year the world produced 96.3m b/d of oil, of which it consumed only 94.5m b/d. So each day about 1.8m barrels went into storage tanks—which are filling up fast. Although new storage is being built, too much oil would cause the tanks to overflow.
Consumers have also taken advantage of technological developments making cars ever more fuel efficient – even if we factor in VW’s scandal -, buildings are better insulated and therefore more energy efficient. On the other hand, the development of clean energy alternatives which have been heavily subsidized by Western governments is now slowly making a dent in the demand for fossil fuel. The real impact, however, will only be felt in another decade or two.
Geopolitically, this means that the key oil exporters, namely the OPEC countries that are heavily dependent on oil revenues to maintain their standard of living for a restless population such as Saudi Arabia, Nigeria, Algeria and, of course, Venezuela will be suffering Heavily.
As we have seen on a number of occasions, financial markets tend to overreact on both the positive and the negative. Right now, the price of oil is testing all-time lows almost daily. There is no longer a connection between the real world of oil production and the financial price of oil. We are likely to see the price remain low for some time but at the same time it could jump back up quite fast. Timing these moves will be extremely difficult. What we can say for sure, is that the price of oil is very cheap right now and consumers are enjoying fillingthe tank of their cars at the gas station. Consumers are therefore likely to spend their spare cash at Starbucks or watch the newest Walt Disney release.
Conspiracy theories and some hard facts
When we speak about oil conspiracy theories abound, especially in volatile and uncertain times. As their name tells it, they are theories: pleasant to discuss but usually without much truth. Let’s turn to facts instead.
The Organization of the Petroleum Exporting Countries (OPEC) was created as a cartel in the 1970s in order to exercise stronger pricing influence in the oil markets. The original signatory countries were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela; these have since been joined by Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Gabon (1975) and Angola (2007). Today, OPEC members produce a mere 40% of the world’s oil output, the cartel’s power of setting prices has become more limited.
Still, in November 2014 Saudi Arabia forced OPEC to keep the taps open despite plummeting prices, it hoped quickly to drive higher-cost producers in America and elsewhere out of business. Interestingly, the higher-cost producers have proven to be more resilient. The US is first and foremost interested in supplying its domestic, gas-guzzling market and if the supply-chain becomes all the more independent from the unstable Middle East, then the better. America’s shale producers added 4.2m barrels a day to global oil production, although only 5% of global production, which had an outsized impact on the market by raising the prospects of recovering vast amounts of resources formerly considered too hard to extract.
With the US becoming a net oil exporter, the symbiotic relationship with Saudi- Arabia, formerly its largest supplier, may no longer be as important strategically. With Iran now able once again to export its oil richness, – it has just announced an increase in production by 500.000 barrels a day – the goal will be less on the price of oil but who, between these two regional powers, can assert its influence in the Middle East and beyond. Both are involved in proxy wars and a low oil price may damage the former sanction-ridden Iran less than the profligate Kingdom of Saudi Arabia. Both will need higher oil prices to shore up their budgets, however, in the meantime the seething rivalry between the rulers in Tehran and Riyadh makes it hard to imagine that these producers could agree to the sort ofproduction discipline that OPEC has used to attempt to rescue prices in the past. They will continue to pump as much as they can and add to the global supply glut.
Low oil prices may lead some of the oil exporting nations to dip into their sovereign wealth funds in order to finance their budget deficits. The budget deficit of Saudi Arabia in 2015 swelled last year to a massive 15% of GDP. Although the country in November 2015 has $650 billioni of foreign reserves (deposits and securities), these have recently dropped by $100 billion. If Saudi Arabia were forced to sell some of its equity investments on the global markets, the pressure on equity markets could be enormous.

Low oil prices have already led some oil companies to moth-ball some highly-publicized drilling projects which amount to some USD 380 billion of investments. In sum, however, the industry has been slow and reluctant to ditch the projects. According to one estimate, at USD 30/barrel, only 6% of the world’s oil production is loss making. Therefore, the tendency of the industry is still to ‘pump flat out’ once the investment has been made. The equity markets have dramatically rerated stocks of suppliers to the oil industry lower. The market estimated that the order books of suppliers of oil rigs, services and steel pipelines will wither away, but it may just be overdone.
Low oil prices are already taking their toll in the shale and fracking industry. In theUS, the number of drilling rigs used topump oil has dropped by 60% as most ofthe projects are only viable with the oil price at around USD 70/barrel. Since mid- 2015 shale firms have cut more than 400,000 b/d from output in response to lower prices. Nevertheless, America still increased oil production more than any other country in the year as a whole, producing an additional 900,000 b/d, according to the IEA. A number of producers see their finance deteriorate fast and raising cash in the financial markets or from banks will only possible for the larger, better companies. Expect a number of smaller and more leveraged companies to file for creditor protection in 2016.
The effect on oil exporting countries
Low oil price will have a destabilizing effect on those nations who depend heavily on their oil revenues to finance their current budget deficits. The longer the oil price remains low, the more difficult it will become to maintain government largesse and in some case just provide for the basic necessities to the local population. We are likely to see devaluations and political unrest in some of the oil producing countries in Emerging Markets.
– With GDP falling, the Russian government could face a budgetary crisis within months.
– Venezuela where inflation hit 140% has declared an economic state of emergency
– Nigeria that depends on oil revenues for 70% of its budget is rationing US dollars inan effort to prop up its currency
– Saudi Arabia announced the listing of its national oil company, Aramco, with the saleof a 5% stake to outside investors.
If oil prices do not recover quickly, some of these nations will face harsh times ahead and will be forced to conceive a future beyond oil. These countries will need to diversify their economic activities to become less dependent on oil revenues. These may not be good places to invest as the current rout in Emerging Markets securities has shown.
Low oil price, so far, fail to boost economic growth
The rule of thumb from previous oil price collapses is that a 10% drop in the oil price should boost world economic growth by 0.1 – 0.5%. With the price of oil having dropped some 75% in the past 18 months, the economic benefits of lower oil price prove more evasive thanbefore. World economic growth seems to struggle as the IMF has lowered its estimates for 2016. The Baltic Dry Index which follows global trade has dropped to a very low reading in recent months. Even the financial environment in the Western countries show some strains: yields from high yield corporate bonds have surged from 6.5% in the middle of last year to 9.7% now. Investors have taken flight from energy companies as a whole and the rout has affected the entire bond market. The markets seem more concerned with the potential drop of demand emanating from oil exporting countries than the benefits of lower oil prices to consumption. It may just be too pessimistic.
What can a private investor do?
The oil price is likely to recover sometime. The industry has pushed back its expectation of a recovery in the oil price until 2017. This may be due to a current excess of pessimism in the markets. We are likely to see strong price swings, both up and down for some time still. However, when oil prices find a bottom, and assuming that this cycle is like previous ones, they will eventually shoot sharply back up due to underinvestment in new wells and natural depletion of existing ones.
If you have experienced precious swings in oil prices – remember the oil shock of 1973? – You may share our opinion that oil is cheap right now. If so, you could buy oil futures and other derivatives. We, however, propose to look at some of the major oil companies that still have sound financial statements and are in a position to pay a very good dividend year after year. In some cases, the return from the dividend is far higher than what you could get for your savings at the bank or on government bonds. On the other hand, any investment in equities should be viewed as a long-term investment as the price of shares can go down before it may go up again.
If you think that the price of oil is much too volatile for a good night’s sleep, there are always opportunities in the markets. With such a low oil price, consumers benefit most and will spend or sometimes save the extra cash. Companies in hospitality or entertainment, financial services and even car manufacturers are likely to benefit the most from this trend.
If you believe that the current turmoil is a sign that the world’s dependency on fossil fuels is coming to an end, you may want to consider alternative energy producers in solar or wind energy. We may add that low oil price currently discourages investments in alternative energy. While the business models in this sector are still developing and most firms have not (yet) been able to generate sustainable profits, some of these companies look appealing for the long-term.
In conclusion
While prices go up and down all the time, it is important to keep calm. Make up your mind of what makes sense to you and place your investments accordingly. If you have any questions on this note or on any topic related to the financial markets, drop us a note or give us a call.
We are happy to discuss these topics with you and please contact us here to arrange a time for us to chat through our recommendations with you.
https://www.imf.org/external/np/sta/ir/IRProcessWeb/data/sau/eng/cursau.htm
