Is Now the Time to Invest in Oil?

January, 2016

The media has widely reported on the crash in oil prices. As measured by the West Texas Intermediate price, oil dropped by 30% in 2015 and is now 67% lower since June 2014 (Federal Reserve of St. Louis). This dramatic and swift price decline has battered stocks within the industry from producers to oil service companies. For years, WindRock has avoided the oil industry due to concerns about all economically sensitive commodities. But now we are wondering: is now the time to invest in oil?

To answer that question requires an appropriate appreciation for the historical volatility in oil prices. Over the last 15 years, oil prices have moved from $18 (April 2001), up to $145 (July 2008), down to $30 (December 2008), and then back up to $113 (April 2011) before their current descent. As measured in inflation-adjusted terms, the current price of $34 equals the low in December 2008 while a continued decrease to $25 will test the low of April 2001. And $25 oil is not unlikely with production at all-time highs and storage capacity filled while global demand falls with weakening economies.

However, a great investment requires more than just a cheap price. Great investments also require an identified catalyst to bring about the price change. While oil prices are certainly low, what catalyst exists to raise them to past averages or even historic highs?

Geopolitical risks in oil-producing countries are an ever-looming candidate, but outside of extremes such as a revolution in Saudi Arabia, it is hard to foresee any other events having a dramatic impact given current unrest and tensions. And even if extreme geopolitical events increase oil prices, it is difficult to determine their timing (how many foresaw the Arab Spring?).

A more likely catalyst and one with an identified timeframe is decreased U.S. oil production. As Rick Rule, CEO of Sprott US Holdings, Inc., recently discussed in a WindRock podcast (which can be listened to here), once public oil producers in the U.S. and Canada begin to write off or revalue their oil reserves, credit lines and debt financings may become severely restricted. Constrained credit may force drilling cutbacks, and U.S. production could decline precipitously, especially in the fracking industry. If the recent decline in oil prices has been caused by an oversupply largely resulting from (as many believe) American fracking, reduced U.S. supply should increase oil prices. As Rick Rule says, “the cure for low prices is low prices.”

An increase in the price of oil to $100 from current prices equals appreciation of 200%. However, despite falling significantly, oil company stocks still possess high valuations and may not increase in lockstep with the price of oil. So how can investors realize significant returns from rising oil prices? WindRock has an alternative.