The price of oil has been in a downward spiral over the past 12 month going from $115 to $37. These drop of over 67% took many if not all investors by surprise. No one at the beginning of 2014 could have predicted what the oil price would be today.
Oil is a cyclical commodity by its nature. When the price of oil is low, like it is at the moment, people are quick to tell you that oil is abundant and new techniques like fracking are able to tap new ever growing reserves of oil. On the other hand, when oil prices are high, those same people will point out that oil in non renewable , there is no cost effective viable alternative to it and that the price will keep rising due to the constant population growth and industrialisation of the developing world.
People have many different predictions about oil where the oil price is headed. One day there will tell you that it is it is going to $20 whilst the next day the same person will tell you it will go to $150 by the end of the year. The only real way to see where the price of oil is headed is by looking at the mechanism that drives it – supply and demand
Supply of oil is increasing
- OPEC maintaining production – In the latest opec meeting in early December, members of the cartel decided not to cut oil production. When the oil price falters, historically you would expect OPEC members to cut supply in order to drive the price up. Because non-OPEC members like Russia and the United States would not cut its production, the leading OPEC member in Saudi Arabia has also refused to cut production as it does not want to lose market share
They are two debates going round as to why Saudi Arabia has not cut production, one being that they are in the same position as everyone else and they badly need any oil revenues and the other is that they want to drive the price of oil down so that US frackers go out of business and sub sequentially the price will be driven back up.
- US Production at record levels – The US oil production has been at record levels over this past year. With the US shale industry boom, it has brought more oil onto the market over the past couple of years. This increase in supply is one of the main attributes of the low oil price.
- Iran production – With the lifting of sanctions, Iran which has the world’s fourth-largest oil reserves, can now trade freely with the rest often world. It is expected the Iran will pump an additional half a million barrels of oil a day into international markets. Over the coming years, Iran is looking to vastly increase its production of oil and depending on the viability of this and the length it takes to get new oil production facilities in place, the oil price is expected to go lower as a result of Iranian oil.
Demand of oil is decreasing
When looking at the price of oil and future trends, the mainstream media always seems to concentrate on the supply of oil. The demand of it is mentioned must less. I believe that at this point the decreasing demand of oil is an even more important factor in where the price of oil is headed in 2016 and beyond.
The worlds economy is slowly grinding to a halt again after seeing a period of recovery since the global financial crises. A recent article by the business insider (Global GDP growth has gone negative for the first time since 2009 (http://www.businessinsider.com/new-recession-might-be-around-the-corner-2015-12?IR=T) showed that the global GDP growth has gone negative for the first time since 2009. The reasons for this are plentiful with one of the main ones being that many countries have binged on cheap debt after the financial crises and as a result of the feds move to start pushing interest rates back up again and the strong dollar , many economies are being squeezed.
As a result of these economies facing challenging times, the demand for oil is decreasing as you would expect thus sending the price of it down.
What should investors do?
The oil price declines should not scare you as an investor. They should be thought off as great buying opportunities. The oil majors such as Exxon , Chevron, BP, Shell and Total are not quite in the once in a generation pricing range but they are in the zone where long term investors can expect to compound their investment by a double digit rate over the next 10 – 15 years.
When industries are in turmoil, it is usually the best time to invest. Just look at the performance of tech stocks after 2002 or bank stocks after 2009. Oil companies are currently in that stage of their cycle. In order to achieve the great return oil companies will produce over the next decade, be sure to invest in quality, and the 5 aforementioned companies tick that list.
At present, due to the payout ratios and strength of the balance sheet, Exxon and Chevron are the best bets for conservative investors. If oil prices are to stay in the doldrums and stay lower for longer, these two companies ill give you better safety than the rest. A more aggressive investor who doesn’t mind dividend fluctuations and just wants a high dividend yield should go with Shell or BP.
Many people look at the recent Kinder Morgan dividend cut and think many oil stocks like Shell and BP will follow suit. If BP, Shell or any other oil major were to cut there dividend, many people will do exactly what they did with Kinder Morgan and sell.
Selling in response to falling profits or even a dividend cut is not such a great idea with oil stocks. It is anti-value investing. The business cycle will eventually change and profits will road back really quickly. That is how the industry has always operated. Value investing has always been about investing in stocks that people hate, often because something is wrong. People didn’t want tech stocks in 2002. They certainly didn’t want bank stocks in 2009. But look at the great returns experiences since these sectors were absolutely hated. Oil stocks seem to be hated at the moment . The low expectation will propel their out performance over the 5, 10 and 15 years.