Panic Creates Opportunity

As the price of West Texas Intermediate (WTI) crude dropped back below $45 a barrel (bbl) for the third time this year — now falling under $40/bbl — it is no mystery why many oil and gas investors might be tempted to exit the sector. As happened during the prior lows, some are calling for much lower oil prices. Investors are left wondering what to do when they hear predictions like this:

Why oil prices could sink to $15 a barrel

“There is no evidence whatsoever to suggest we have bottomed. You could have $15 or $20 oil — easily,” influential money manager David Kotok told CNNMoney. “I’m an old goat. I remember when oil was $3 a barrel,” said Kotok, whose clients include former New Jersey Governor Thomas Kean.

A recent comment left in our Stock Talk forum echoed others I have heard lately. To paraphrase, “With some pundits arguing for $20/bbl oil and others arguing for $70/bbl oil, how am I to make heads or tails of any of this?”

When deciding to move money in or out of energy equities, the foremost question is “Do I believe the underlying commodity is fundamentally undervalued or is it overvalued?” If I believe it to be undervalued, then I focus on companies with strong underlying fundamentals. If I believe it is overvalued, then I will obviously be more cautious.

So the question of the day is “Is $40/bbl a sustainable price for WTI crude?” The previous two times oil dropped into the low $40s this year, it promptly ran back up to at least $50/bbl. Might that happen again?

Here is the basis for two very different views on the future direction of oil prices. Let’s call the bear case that which has oil prices averaging $30/bbl in a year or three, and the bull case one that assumes an average price above $60/bbl over the same time frame.

The bear case for oil is one in which U.S. production continues strongly at current prices. Alternately, as someone recently argued, “abundant low cost reserves will soon be available from Iraq, Iran, Kuwait and Venezuela.” (Never mind that most of Venezuela’s oil is expensive-to-produce heavy oil).

The bears also believe that demand for oil is slowing, driven by the economic growth slowdown in China. Another bearish plank is that renewables are poised to take an increasingly larger market share from petroleum. Finally, many bears believe that growing crude oil inventories must inevitably lead to falling prices.

The bull case argues that $40 per barrel is an insufficient price to meet growing global demand, and that capital spending cuts that began when oil was still above $50 are already crimping production.

Low prices also tend to spur demand, with the International Energy Agency noting recently that “global oil demand is rising at its fastest rate in five years in 2015.”

This combination of factors will inevitably drive up oil prices as falling supplies fail to satisfy growing demand. Bulls also believe that investors will anticipate these changes before they are fully manifested, and will bid up the price of crude as it becomes obvious the direction things are headed.  

Which case has more support? I am solidly in the camp that doesn’t believe the low prices we are seeing today can be sustained for much longer.

At the beginning of 2014, I thought $100/bbl was too much for oil. In fact, I predicted oil prices would fall in 2014. They stubbornly refused to until mid-summer. To be clear, I didn’t believe prices would plummet to $40/bbl, just that at $100/bbl supply was outpacing demand. It took longer than I thought for the price to respond, but then it responded in a big way. (I am also aware that this year I predicted that the price of WTI would not close below $40/bbl. Of course I will miss some; my goal is to be right more than I am wrong.)

But now I believe the pendulum has swung too far in the other direction.

Please ponder the following questions. If you could freeze oil prices at $40/bbl for the next year, would supply be higher or lower a year from now? How about demand? Unless you believe $40 is an adequate price to keep up with crude demand that is rising by more than a million barrels per day each year, then you likely agree with me that oil prices have to rise. Whether they drop further in the short term is an open question, since commodity markets are notorious for overshooting.

Panic creates opportunity for those who are well-informed and unafraid of short-term losses. If you are a long-term investor, $40/bbl oil is an opportunity that hasn’t been seen since 2008-9, after which the oil markets went on a five-year bull run.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)