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Oil: contrarian ‘Spring’ bet or April fool?

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Written by: Darius McDemott
18/01/2016
Last week, the price of a barrel of oil fell below $30 – a fall of almost 80% from its peak of $147 in July 2008, with most of the fall coming in the past 18 months.

Some analysts have suggested it could fall as low as $10 per barrel, at which point oil would become cheaper than some bottled water!

Could the price of oil really fall that far? Quite possibly, especially in the first quarter of this year. The momentum is in a downward direction and there is no catalyst in sight to stop it. As we head into the spring, things may well get worse before they get better.

But on the other hand, could the oil price recover to $60 in the next three to five years? Equally possibly in my view. And even if it only gets to $45 it would be a 50% return on your investment at today’s price. The contrarian in me is itching to invest.

Here are three bull and bear points currently fighting each other in my thought processes:

Bull:

  • It’s cheap! Oil has fallen almost 80% from its peak and is down 17% this year alone – and we are still in January! Energy equities have underperformed the broader market (using the US as a proxy) for longer than was the case after the large price declines in the 1970s. Compared with the price of other US sectors, US energy companies are actually at their cheapest level for 50 years. Not only are investors underweight the energy sector, a significant amount are actually shorting it. When everyone hates a sector, contrarians start to like it.
  • Oil demand is strengthening. Despite the continued slowdown in China, and concerns about global growth generally, oil demand growth last year was the strongest it has been since the post financial crisis bounce in 2010. In the US, vehicle miles traveled are on the rise and the market share for sales of SUVs in both the US and China (the world’s two largest economies) outgrew that of smaller cars by a significant margin. Interestingly, gasoline consumption growth in China has lagged behind the growth in numbers of passenger vehicles, which suggests some pent-up demand.
  • Supply is expected to reduce by 2017. The Saudis are deliberately keeping OPEC oil production high in an attempt to keep market share from non-OPEC producers and ensure a lasting re-set of the oil price. The incredibly low prices will eventually force supply to fall. If it costs significantly more to get it out of the ground than you get back when you sell it, you stop extracting it. It’s simple. Capital expenditure of US producers has already fallen by 50%, Petrobras has cut its investment by around $32bn and BP has just announced job cuts. They simply don’t have the money anymore.

Bear:

  • Dividends are likely to be cut or stopped. This is bad news for income seekers, especially in the UK, as oil majors make up a large part of our market. But the energy sector simply doesn’t have the spare cash anymore as profits have been slashed. No cash also means no capital investment and we’ve already seen this start to be cut back. The sector is experiencing its longest downturn since the 1990s and it could take a number of years to recover.
  • Slowing China. Demand is ok at the moment – it’s just that supply is unusually high. But if China continues to slow and demand starts to falter, even if supply is reduced we are still in the same situation. A low oil price is good for filling up our cars, but generally a bad indicator of the state of the world economy. Prolonged deflation is also a bad thing, as evidenced by two decades of it in Japan. If asset prices fail to rise, people and companies stop investing and it becomes a vicious cycle.
  • The rise of new energy. The world needs to stop burning fossil fuels and at the recent summit on climate change, more progress was made to stop emissions. 50% of greenhouse gases have been emitted in the past 27 years alone. We want the likes of China and India to develop, but ideally they would use new energies, not coal and oil. So the future is in renewable energies and some think that this revolution is upon us, with electric and hybrid cars likely be the most popular choices in just a few years, and countries like Germany leading the way with 43% of electricity generation already coming from solar, wind and hydro power. This doesn’t bode well for oil in the medium, let alone the long term.

So the long-term outlook for oil and ‘old’ energy isn’t exactly bright, but then the same has been said about the tobacco sector, and that has managed to prosper for a good couple of decades longer than expected.

Despite the obvious dangers, I come out on the side of the bulls right now. I wouldn’t invest the whole of my pension pot in the asset class, as it’s likely to remain very volatile, but personally, I think a small investment now could reap rewards in the next couple of years, and if the price falls further, I may well buy more.

If you are of a like mind, specialist funds in this sector are few in number, but a couple worthy of considerations are Guinness Global Energy, which is on the Chelsea Selection, and Investec Global Energy. Or you could always consider oil exchange traded commodities (ETCs), which are a type of exchanged traded product.

Darius McDemott is managing director of Chelsea Financial Services

 

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