In the
past year, investors have been split on oil market. Some love it, some hate it.
But you have to give credit where it is due. If there is one thing the oil
market knows, it is how to party. And like in any party, when the music is
playing, everyone is happy and dancing. But what happens when the music stops?
Investors don’t stick around to assess the mess. They run.
This is
exactly what is happening to the price of oil. The music has stopped playing
causing some investors to leave the party. We might be able to determine the
drivers pushing investors away from the oil market, but the question remains.
Should investors follow the hype? Or should investing in the oil market be
looked in a more subversive and intuitive light?
I would
argue the latter. Investing in the oil market is not child’s play. It requires
a lot of due diligence on the part of the investor. Bear in mind that there is high
levels of volatility when it comes to oil investing. This year, for instance,
crude oil prices have declined by over 20% since June with predictions coming
in indicating a further drop by year’s end. But isn’t a lower oil price a good
thing? As always, it depends on who you are. The average Joe wanting to fill up
his tank at the petrol station might be happy, but the expert investor looking
to buy oil futures might not. For oil investors, a lower oil price means
substantially reduced production margins. Investors now have to focus on
production costs to identity winning companies. What we see happening in a time
of high oil prices is a culture of companies accumulating high prices within
cost assumptions. This can get terribly risky when companies begin to account
for high costs within the budget of ongoing projects. Take Senex Energy Limited,
for example. The Australian energy company recently released its September
quarter earnings with auspicious results. Q1 production was up 26.7% with sales
up 27.6%. It is interesting to note, however, that despite production being 10%
higher, revenue for Q1 2015 was actually lower that Q2 2014. This shows that
persisting declining oil prices may cause companies like Senex to slow down is
growth targets to account for significantly weaker cash flow. Senex is a very
ambitious company. It plans to substantially increase oil production by a range
of 3-5 million barrels by fiscal year 2018. But with lower revenue due to lower
oil prices, what we might see happening is that Senex would likely borrow
extensive capital to compensate for a lack of revenue. Low oil prices may
eventually lead the company to acquire debt in order to fund project expansions.
Therefore, one can see the vitality of looking at oil prices from a wider
spectrum. In the short run, Senex is safe. But if oil prices continue to follow
a downward pattern then it can cause the company to slow its growth rates.
In the
short term, I would argue that oil prices will be highly volatile especially
given the pattern of declining prices. The golden ticket for oil investment
lies in the long term and it lies in emerging American markets. In the 12
months ending June, 2014, U.S. oil production grew at a phenomenal rate of 1.3
million barrels per day. In fact, since 2011, the U.S. has added 3 million
barrels per day (what the UK produced at its peak in 1999). Market data is also
reflecting auspicious news relating to oil investment funds. According to
MoneyNews, investors are buying into funds that track oil prices at the fastest
rate in two years, all in speculation that oil will come out of a sluggish bear
market. Just this month, the four biggest oil exchange-traded products listed
in America received an aggregate $334 million. This is the most since the
October 2012. It doesn’t stop there, money has been flowing into renowned U.S.
Oil Fund. This is the biggest ETP, receiving just north of $100 million. The
fund is responsible for tracking WTI prices. WTI for December delivery was
recently seen gaining 40 cents to $82.89 a barrel.
Furthermore,
it seems that in the immediate short run, volatility amongst oil prices may
soon subside. Banks including BNP Paribas SA and the Bank of America Corp are
predicting that the rout in the oil market may be over. It is clear to some
that we have reached the level indicating a bear market. If we look at WTI and
Brent Crude, we will note that both have plunged more than 20% from their June
highs. Hence meeting a common definition for a bear market. Most oil investors
tend to be of the opinion that the long-term price of oil should stagnate at
$100. Following this trend, it would appear that the WTI future is on the right
track. According to Bloomberg, the future gained 1.7% as Saudi Arabia cut crude
oil supply. This was the biggest increase since October 17. Brent crude oil is
following a similar pattern. The future is up almost 3% post Saudi cuts.
Currently it sits at US$86.83 per barrel.
Disclaimer: This article was
posted with the permission of a third-party contributor and the opinions
contained therein do not necessarily reflect those of Smallcappower.
Smallcappower does not endorse any investment advice provided by these third-party
contributors.
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