Oil Is Down. Is It Time To Buy?

June 29, 2017

Oil Is Down. Is It Time To Buy?

  • Even if oil prices are volatile, demand is stable and costs are known. This allows us to find the balance value and trade around it.
  • With oil above $50, all big producers are profitable and expanding investments and production, but that’s not a good long-term sign for oil prices.
  • For low risk, high return investments, investors should wait for some kind of panic that pushes oil prices below $40.

Introduction

In March when oil prices were around $54 per barrel, I wrote an article that described a low risk, high reward investment strategy related to oil.

The article, available here, advised readers to wait for oil prices to fall much lower to lower investing risk and increase returns because the long-term oil price is defined by supply and demand surrounding production costs while in the short term, anything can happen as OPEC news can easily move markets.

Oil prices are currently more than 20% lower than they were in March, so it’s time to take a deeper look at what’s going on with oil and potential oil investments.


Figure 1: Oil prices in the last year. Source: Bloomberg.

Consequently, oil related ETFs are also down significantly.


Figure 2: U.S. Oil exploration and production ETF (NYSEARCA: XOP). Source: Yahoo Finance.

To determine the risk reward of investing in oil, it’s important to look at production costs, and, of course, supply and demand.

Supply & Demand

First, oil stockpiles are extremely high and at record historical levels.


Figure 3: U.S. oil stockpiles. Source: U.S. Energy Information Administration.

This means that as soon as oil prices cross $50, as they have in the last 12 months, production increases significantly, especially in the U.S. We can see how the number of oil rigs in the U.S. and Canada have more than doubled in the last 12 months as oil prices stabilized.


Figure 4: Number of North American oil rigs. Source: Baker Hughes.

The conclusion is that the balance price is lower than $50, because as soon as it gets higher than that, new supply brings it back down again.

What’s Going On? 

Many producers, especially shale producers, are profitable at oil levels above $50, thus U.S. oil production has increased and has consequently pushed oil prices lower. The demand for oil is pretty stable and growing at a small rate as cars become more efficient or even electric.

What I want to show is a longer-term outlook as that is the only way to understand at what price level oil investments provide a margin of safety.

What’s significant from the sector is that most big producers keep spending lots of money on PP&E additions and investments. Most of them invested more money than what their operating cash flows were in 2016.


Figure 5: Comparison of operating cash flows and investment spend among big oil producers. Source: XOM.

On top of the above, even with very low oil prices in 2016, all major oil producers managed to operate profitably. This means that we are far from a bottom in oil, especially if the demand starts to drop faster than expected due to improved engine technology and more electric vehicles on the road.

For example, if oil prices stabilize around $40, Exxon Mobil (NSYE: XOM) will still manage to have operating cash flows at a level around $20 billion, just as it did in 2016.


Figure 6: XOM’s estimated cash flows from operations and asset sales. Source: XOM.

The positive cash flows at around $40 keep producers investing in projects that offer attractive returns even at oil prices below $40, and there are plenty of such projects.


Figure 7: XOM’s Liza project expected to start-up in 2020 has a resource of 1 billion. Source: XOM.

If the above returns are attractive at $40, oil investors should be even more concerned by Lundin Petroleum’s Norwegian development plans where the project breakeven is at an oil price around $25.


Figure 8: Lundin’s project gross resources of 2 to 3 billion barrels at low cost. Source: Lundin.

Conclusion

Oil prices below $50 might look like an attractive entry point, especially when compared to oil prices of above $100 from a few years ago, but the amount of new investments, low production costs, and current operating profitability indicate that the balance price for oil is around $40, if not lower.

At current oil prices, many investments will turn out good but won’t be great. However, any kind of market panic that would push oil prices below $40, or even toward $30, would create an environment where amazing returns could be achieved at low risk. So, I’ll be prepared, but won’t swing yet.

Keep reading Investiv Daily to be up to date with interesting investment opportunities as we sift the world to provide you with low risk, high return investment opportunities.

By Sven Carlin Commodities Exxon Mobil Investiv Daily Oil Share: