The investment case for oil

Crude oil is the most important natural resource in the industrialised world. Yet since mid-June 2014, oil has more than halved in value. So where’s the price heading now? And how can you profit from it?

Crude oil is the most important natural resource in the industrialised world.

It generates heat, powers machinery and fuels engines. Its components are used to manufacture almost all chemical products ranging from plastics and paints to detergents and even medicines. Forty per cent of all textiles contain oil.

In short, life without crude is impossible. Yet since mid-June 2014, oil has more than halved in value. So where’s the price heading now? And how can you profit from it?

You’ll probably have heard about a number of possible reasons for the plunge in oil. These include global demand being trimmed, higher production from American “frackers” (who extract oil from underground shale rock formations) and several conspiracy theories. In fact my colleague Jim Rickards has a very cogent explanation:

“Saudi Arabia has the world’s largest oil reserves and the lowest production costs. It set out last year to destroy the fracking industry in the US and Canada by keeping the price below $60 per barrel. Frackers fought back in the short run by pumping more oil to generate cash flow. Now old wells are running dry, new wells are non-economic and parts of the fracking industry are facing bankruptcy”.

But there’s more to this than Saudi vs the frackers

Meanwhile, another reason hasn’t received anywhere near as much air time.

Speculation. Here’s what a recent study by two IMF economists says on the subject:

“When speculation is short in duration, it has the weakest impact on oil prices and demand shocks have the largest. However, when speculation is allowed to have short and long-term effects, it is the main contributor to the volatility of oil prices”.

In other words, when speculators have decided they really hate something, its value can become seriously depressed.

Speculators are influenced by sentiment. And this has soured as once-bullish oil analysts have turned bearish.

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Yet sentiment can reverse just as quickly. So what could be the catalyst for an upswing in crude prices?

In fact, demand has remained consistently firm even when crude prices were much higher. Now the picture is now showing a big improvement.

Oil demand surged in the first six months of 2015 versus the same period last year, according to national estimates submitted to the JODI (Joint Oil Data Initiative) producers’ and users’ database by the 59 countries that account for 75-80% of global oil consumption.

JODI submitters said that in this year’s first six months, consumption averaged 71.4m barrels per day (bpd), 3.3% more than in H1 2014. Forty-six out of the 59 countries reported higher oil use in 2015 compared with last year.

China accounted for slightly over half the total increase, with reported consumption of petroleum products up by more than 13%. The US, India, Turkey, Saudi Arabia and Korea also saw substantial usage increases.

While there are caveats about the reliability of China’s data, the demand hike is at least a move in the right direction. Any Chinese economic stimulus package would boost oil use even more.

Over to the supply side, where there have been fears of the market being flooded. But as Jim has noted, lower oil prices are now crimping potential US oil output.

Oilfield services company Baker Hughes reports on the number of rigs being used to extract oil & gas across the US. And the country’s rig usage is plunging again.

us oil rig count

I believe that a collapsing rig count will eventually lead to big cuts in US oil & gas production forecasts. This will mean a significant rebalancing of supply and demand for crude in coming months. Sentiment towards oil will also improve.

The big producers are cutting back

Further, the major integrated oil players are rapidly reducing costs, lowering capex and shelving marginal projects. So they aren’t replenishing their reserves. Brent crude in particular is very sensitive to worldwide reserve levels.

An oil price rally would be hastened by any decision by the OPEC oil cartel, and Saudi Arabia in particular, to cut output. Right now OPEC says that’s not on the cards, but it could yet happen.

There are plenty of risks involved in oil investment, of course. It’s becoming more expensive to burn fossil fuels. Politicians – and now central bankers too – are warning about the economic effects of climate change. That’s set to lead to higher taxes on carbon emissions. And over the very long-term, replacement energy sources are likely to make fossil fuels redundant.

I also accept that there’s likely to be a fair amount of volatility over the coming months. But over the next few years, oil is still set to play a vital role in the global economy.

Crude is a finite resource that the world is using at an increasing rate. I reckon that it’s not a question of ‘if’ prices will recover, but ‘when’. And it won’t take much to drive oil, and oil shares, up from today’s levels.

As demand steadily increases and supply is curbed, I believe that within two years Brent crude could return to the $80 per barrel area (and maybe higher). That would give upside of a third from today’s level.

Depending on their exact exposure to the commodity, many oil-related shares could appreciate by considerably more.

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