A Low Risk High Reward Investment Approach To Oil

March 2, 2017

A Low Risk High Reward Investment Approach To Oil

  • Oil prices have stabilized, however, both further upside and downside are possible as nobody knows what OPEC will do or decide.
  • U.S. shale producers are back in the game as oil prices stabilize above $50.
  • A low risk high reward investment strategy is to start investing in oil at prices below $40, or even $30. If oil doesn’t reach those levels, well there will always be other investment opportunities.

Introduction

Oil prices have relatively stabilized in the last three months after three years of high volatility.


Figure 1: WTI crude oil (Nymex). Source: Bloomberg.

As you probably know, oil prices are a result of demand and supply in the long term, and market sentiment in the short term. However, market sentiment is also strongly influenced by supply and demand. Another issue with oil is that the market isn’t exclusively governed by economic rules as some countries or cartels can have a significant influence on oil prices.

Now, those of you who have been reading my articles probably know that I look for low risk high reward investing opportunities, so you might be wondering why I’m looking at oil. Well, what I want to know is at what price is oil relatively in balance so that I can buy when the price is lower than that. A price below its balance price should be unsustainable due to production costs or other market imbalances like quotas, agreements, or geopolitical issues. We could say that after the shale oil revolution and consequent OPEC (The Organization of the Petroleum Exporting Countries) intervention, oil prices have stabilized at above $50. This means that any price drops below $40 could indicate a low long term risk high reward investment opportunity. And, there is one thing I know for sure, oil won’t be stable for long.

Oil Production Is Picking Up

Well, there is plenty of oil and global producers can easily increase production if prices allow it. On one hand, we have the OPEC which, back in December 2016, had reached an agreement to curb production by 1.2 million barrels per day, or 1% of global production in order to keep prices stable. Since then, oil prices have stabilized but potential disruptors are lining up. The first potential disruptor comes from the fact that OPEC doesn’t have the power it enjoyed back in the 1970s. Many countries, like Russia, depend on oil and can easily become greedy with higher oil prices and increase their output. If one producer starts increasing production, the rest will follow and a new supply glut will arise, sending oil prices down again.

The threat of higher production doesn’t only come from countries outside of OPEC. OPEC members are notorious for running their taps a bit more than agreed once a deal has been reached and prices begin to increase.


Figure 2: OPEC quotas, output and cheating – as soon as a quota has been agreed on production starts to go up. Source: Credit Writedowns.

Further, OPEC countries reached an agreement for only the first 6 months of 2017, so we’ll see what will happen in July.

The above would describe the usual oil cycle, but many forget that there are new players not constrained by OPEC or Russia but who obey only market forces. They are U.S. shale oil producers. At oil prices below $40, many U.S. producers weren’t profitable and were forced to close, but as prices went up, those producers are coming back to the market.


Figure 3: U.S. oil production. Source: FRED.

Increased production coming from producers that had to shut down due to low prices could lead to another supply glut and create excellent investment opportunities as it is very likely that the same cycle will repeat itself.

Conclusion & Investment Thesis

After the effects of the shale oil revolution and excessive over-investments have been absorbed by the market, we are looking at a new balance. Nobody knows where oil will go in the future, but I know that if it falls under $40 or, even better, $30, it becomes a very attractive low risk investment opportunity because global producers simply don’t find that a sustainable level. Oil prices can remain low for a while as some players try to push out others, but after the dust settles, producers will reach an agreement on production quotas like OPEC did back in November 2016 and prices will go up again.

The beautiful thing about investing is that you don’t have to do anything. In fact, knowing when not to move is an essential quality of successful investors. Therefore, you don’t have to be invested in oil at all above a certain level as it’s risky. However, if you don’t like to risk much, you can just wait for oil to drop below $30. I’m not saying oil will hit $30, but it is possible and if it happens, you can buy oil producers on the cheap. Eventually, some agreement will be made and those stocks will surge.

Apart from understanding when to do nothing, a successful investor has to also accept volatility as a benefit, not a curse. If oil prices drop to $30, there is a possibility that due to market panic, they may drop even more, perhaps even to $20, some market pundits were even calling for oil at $10 a year ago when oil was at $30. Volatility is inherent to investing, so be prepared.

By Sven Carlin Commodities Investiv Daily Oil Share: