Are You Prepared for an Oil Crash?

Do you have a contingency plan for a seismic commodity shock?

And by this, I don’t mean your routine 20 percent drop in the price of oil. I mean something closer in magnitude to the 80 percent peak-to-trough decline in the second half of 2008, as the US financial crisis turned into a global recession.

On July 3, 2008, the price of a barrel of West Texas Intermediate (WTI) closed at $145.31. By Dec. 23, the price had fallen to $30.28. The crash took down all grades of crude in all geographic regions.

Unsurprisingly, oil-related stocks were hammered. As the price of crude fell, the share price of current Conservative Portfolio holding Chevron (NYSE: CVX) fell 40 percent by early October 2008, before beginning to recover. ExxonMobil (NYSE: XOM) fared better, only falling 27 percent during that time frame. Current Growth Portfolio holding Schlumberger (NYSE: SLB), on the other hand, took a shellacking, falling 62 percent by yearend. Suncor (NYSE: SU) also fared badly, falling 70 percent by the end of 2008.  

Even though refiners usually see their profit margins go up as oil prices decline, the second half of 2008 also hit Valero (NYSE: VLO) and Tesoro (NYSE: TSO) hard, as their share prices declined by over 40%.

Every energy investor ought to consider how they should and would respond in the event of another oil price crash, and in that sense the second half of 2008 is instructive. It’s important to have a well-thought out plan based on your personal risk tolerance, which isn’t necessarily the same as my own.

crude chart

Let me briefly review my views on oil. I am extremely bullish on its price over the long term, for several reasons. One is that there is no scalable, economically viable replacement on the horizon. Oil rose to prominence as the world’s dominant transportation fuel for three key reasons: cost, convenience and abundance. No alternative fulfills all three criteria, although some fulfill one or two. Oil presently makes up a third of the global energy mix and is without a doubt the most irreplaceable component.

In Europe, consumers pay the equivalent of $300 to $400 a barrel for fuel as a result of taxes, but even at that inflated price alternative fuels have failed to displace oil as the dominant transportation fuel, despite receiving tax perks.

Global demand for oil grew even as oil prices exceeded $100 per barrel. From 2005 to 2010, oil consumption in the developing countries of the Asia-Pacific region increased by 3.6 million barrels per day (bpd). Other developing countries showed the same trend during that period of rising oil prices. Consumption increased by 1.6 million bpd in the Middle East, by 1 million bpd in South America, and by 450,000 bpd in Africa.

I expect demand for oil to continue to exert upward pressure on the price, and as a result I believe the long-term prospects of the oil industry are very good. I expect oil companies, oilfield service companies and pipeline companies to outperform most other sectors.

However, as we saw in 2008, the price of oil can briefly collapse, taking oil-related companies down with it. What is an investor to do in a case like this? If the price of oil begins to decline tomorrow, and ends the year down 50 percent (however unlikely that is), at what point do you exit your oil-related holdings?

For me, the answer is that I exit positions only if I think the long-term prospects for the sector — or for specific companies — have worsened. Otherwise, I don’t exit on the basis of a specific percentage decline in share price. I only set stop-losses for short-term positions, and most of my energy holdings are not short-term. Therefore, I didn’t exit most of my oil-related holdings in 2008. In fact, at the end of the year — near the bottom — I added to my positions because I felt there was no way $30-per-barrel oil was sustainable for very long.

If your investment horizon is relatively short, you need to have an exit strategy based on your risk tolerance. Unless its prospects worsen, I am not going to sell Chevron if the price falls by 25 percent, because the price can and will recover quickly, as 2008 demonstrated. If you bought Chevron at the top in 2008, you have received 4.5 years of nice dividends, and the share price is almost 20 percent higher today than it was at its 2008 peak (even though the price of WTI is $50 per barrel lower).

History has shown that the price of oil can be extremely volatile. As a result, energy stocks whose profits are correlated with the price of oil can be volatile as well. So every investor in this sector should have either an exit strategy in place or patience for the long haul.

The price of oil a month or six months from now may be lower than it is today, but I strongly believe the price in five years will be higher — and possibly significantly higher — than it is today. As a result, I believe that patience will be rewarded in companies with solid management.

Stock Talk

Add New Comments

You must be logged in to post to Stock Talk OR create an account