Time to Buy Oil? A Lesson in Trading

Anyone who knows me and my investment strategies well will know I’m not fond of commodities, in fact I’m notoriously against buying gold.  The rationale is simple, a productive asset (one where the base value is maintained but it also grows or puts out cashflow) such as a company or piece of land will by nature perform better over the long term all else being equal than a commodity will since the commodity by nature doesn’t grow.  In other words while you might invest in assets such as land and companies the strategy with commodities is to trade them and I tend not to take a trading strategy.

This being said there are exceptions and oil today is one such exception.  I’m buying oil and strongly recommending those I know to do the same.  That doesn’t mean you should run out and do it, everyone’s situation varies but it means I expect oil to produce strong returns in the near future.

What’s the big deal with oil?

Most commodity markets are fairly efficient based on the natural dynamics of supply and demand, much more so than companies or even real estate because they are much less complex, there is less to know.  Whereas in a company there could be poor management, or competition, or a million other factors aside from market conditions that affect the value of the company in the case of a commodity it’s really only the market conditions (supply and demand, whether artificial or not) that matter.

So what’s the key when it comes to commodities?  Same principle as normal, buy low, sell high.  The question is how do you know when it’s low or high?  In the case of stocks and real estate I recommend judging based on the income generated or income they are likely to generate in the future.  When it comes to commodities there is no income potential so you’re essentially betting that the supply will decrease relative to the demand.  The problem I have with gold is supply and demand are completely artificial based purely on market speculation than on real consumptive forces.  Commodities such as oil are different, they are based mostly on real consumptive forces no one really plans on buying barrels of oil to store in a vault as a store of value hedging against the decrease in commodities, etc.

These principles established we have another principle, which is critically important in both investing and trading.  Something might appear to be low but more often than not the market is right, so to beat the market on a consistent basis you need to know something the market doesn’t.  In other words you might look at a company whose stock falls and say “oh it used to trade at $100/share now it’s down to $50/share, that’s a good deal because it’s half price!”  But really the reason the market has decreased its value is because the projected outlook and profitability of the company has decreased so what looks like a stock on for half price is really a fairly priced stock based on the current market conditions so unless you have a reason to believe this is short lived that is better than what the market sees you’ll probably not do well buying that stock.

Same concept is true for a commodity like oil.  Let’s say some revolutionary new alternative energy source was released tomorrow (a bit like what happened to Uranium when cold fusion was first announced), you’d likely see the price of oil drop dramatically because the implication is the demand for oil will decrease as it will be replaced by this superior energy source.  (In practice implementation time of the new energy source, etc. might mean it would have little effect so this example is strictly for illustration purposes).  In other words when the price of oil fell it wouldn’t be a good buy because the market has changed and the price is not likely to ever recover as it’s been fundamentally changed by this new technology.

To consistently make good money then you need to see an opportunity where the value of the commodity or investment has fallen to below what it should be worth under normal market conditions and understand how and why it will correct in fairly short order.  This is where the uncertainty of the 2009 stock market crash comes in.  Companies like GE might have been on sale for 50% off but they weren’t necessarily clear purchase opportunities for most people because no one knew how deep the recession would go or how long it would last, the current prices might have been new fair prices for the foreseeable future.  It turns out with hindsight that this was a great purchase opportunity but it was a lot harder to see in the moment.

How does this apply to oil?  Since the summer oil has fallen from around $100/barrel to less than $50/barrel, a dramatic decline.  On the surface this is potentially a “buy low” opportunity, but let’s look deeper.  We evaluate as follows:

First, we need to understand why it has fallen dramatically so we can understand that this isn’t a fundamental change in the value of oil.  We can evaluate this through the answers to a series of questions.

  1. “Was $100/barrel a relatively fair market price?” In other words dropping from very high to much lower isn’t necessarily a sign of the asset being a good deal today, it might have simply been overpriced before.  This was a fallacy many made when they pointed to houses in 2009 worth half what they’d been selling for previously, the houses weren’t worth what they’d sold for at the peak, they were selling for inflated prices due to the market conditions and the real value was considerably lower.
  2. “What has changed in the market and what’s a new fair value based on the current conditions?” Using the real estate example maybe previously a property was in a good neighborhood but since then it’s become violent and gang infested with a lot of drug use, etc. so it’s no longer as desirable.  If this is the case it might still be a good deal but based on a new valuation so the question is what’s a fair valuation now based on present and projected market conditions?
  3. “Why has the value dropped lower than it should have based on the current or changing market conditions?” Markets over reaction and they under react the important thing to understand if you’re going to predict changes is why so you can apply logic to whether they’ll correct or not.

Before moving on we’ll answer these questions for oil.  Was $100/barrel a fair market price?  At the time, loosely yes maybe slightly lower, but oil stayed relatively stagnant for quite a long period of time.  It’s an environment where the fundamental drivers haven’t and aren’t changing very much.  Production levels typically don’t adjust by more than a few % per year and nor does demand.  Furthermore the market is fairly efficient with global distribution and exchange meaning opportunities for pockets of inefficiency in buying or selling are rare and typically quite isolated leaving little room for long term exploitation (production is a whole other matter but that’s not what we’re referring to here).  We can also look at production costs, which throughout much of the world have become fairly high in the $60-$70/barrel levels (it varies based on what reports you read and it depends on where but the likes of US shale development, Canadian tar sands development, Russian development, etc. hovers in this range with a margin of safety).  These production costs give a sort of guidance around what levels are fair in the market as well since it determines what levels justify added production.  Production costs are substantially lower in places such as the Middle East, but the market overall gets averaged.  In other words yes given the current and expected demand as well as production somewhere in the $90/barrel range it was trading at was quite fair for those market conditions.

What’s changed then and what’s a fair new value?  Here beyond just the immediate factor, which is OPEC specifically the Saudi policy regarding oil production/reserves and their pricing targets let’s look at the big picture.  In the last few years changing US oil policy and improved technology have resulted in massive increases in US oil production, which has decreased the US demand for crude.  Additionally, the global market has in general been fairly slow, China’s economy is slowing in its growth, etc.  Finally, additional technological efficiencies and developments both on the energy production side in the form of alternate energy sources and on the consumption side efficiencies in how we use energy such as more fuel efficient cars, etc. have helped to limit demand relative to supply.  In this environment the case for sustained moderate prices can easily be made.

The specifics of this situation in terms of what triggered the dramatic change in oil prices is OPEC decided to introduce a price target substantially lower than the then normal price level and to achieve this by flooding the global market with additional reserves driving down the prices.  Based on this new factor one might expect that somewhere around a $70/barrel price is more reasonable in today’s market conditions.

Why has it corrected so far below these levels then?  There are two key factors, the first logical the second emotional.  On the one hand there’s a temporary increase in the amount of oil available on the market relative to the demand (demand hasn’t changed much) as OPEC and specifically Saudi releases reserves onto the market but existing more expensive sources remain.  On the other hand as prices are falling fairly rapidly and dramatically the drama is triggering an emotional market response whereby there is more selling and less buying than normal as players wait for the market to settle and see where prices fall.

Now that we’ve answered the first questions the final question becomes:

“Why is this a short term inefficiency that will be corrected fairly quickly?”

To answer this we can look at numerous data points:

  1. As prices fall intrinsically this will lead to increases in demand because the costs of consumption will decrease. You can probably already observe this at the pumps of gas stations as it becomes more affordable to drive people are more willing to drive and to drive more.  This effect will take place across the globe and the system increasing the demand, which has the effect of increasing prices.
  2. As prices fall the high cost producers will decrease production thereby reducing the supply in the market (companies that have a $70/barrel production cost aren’t going to continue to produce if the price of oil is $50/barrel). Reducing the supply in the market will have the added effect of increasing prices.
  3. Supply is artificially high due to opening reserves and as these short term reserves are depleted prices will return to more normal levels.
  4. It’s not in the best interest of anyone including the Saudis or OPEC to have prices at levels as low as we are seeing right now. At say $70/barrel it can make sense because they can make up for decreases in price with increases in market share as the higher cost producers are forced out of the market at least temporarily.  But at say $50/barrel the economics aren’t favorable to any of those nations, which gives them an incentive to limit supply in order to drive the prices up to a more reasonable level.
  5. We can determine norms by comparing various phases in the market over the last 10 years. The last time prices were down at these levels was in a very recessionary economy post 2008.  Even as the economy sat in a fairly uncertain state prices were around $60/barrel.  Today the economy and global demand are much greater than back then, factors which don’t justify prices as low as $50/barrel and below.
  6. Anytime an asset gets cheap investors step in and start regulating the demand forces and trigger the start of a turn around.

At $60/barrel oil wasn’t a great buy because there wasn’t a strong margin of safety.  At $50/barrel or lower it is a great buy because the margin of safety is significant.  I’m expecting to see a 30% increase to at least $65/barrel sometime in the next 12 months if not sooner and making purchase decisions accordingly.  When oil reaches that level I’ll plan on selling because beyond that point, though it might rise much higher there is an element of uncertainty and no real margin of safety unless of course something changes dramatically in the market between now and then.  If it were a productive asset I might be willing to hold at that point based on the productivity of the asset but as a commodity it’s a trade, get in and get out, cashing in on the volatility.

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