Is It Time To Invest In Oil?

Jan 18, 2016

The S&P 500 is down 8% since the beginning of the year. This has been the worse two-week start in the stock market’s history.  One cause frequently quoted is the low price of oil, which negatively impacts the energy sector. Is this a buying opportunity?

Good for Economy and Consumers

Before we talk about the investment opportunities created by low oil prices, it is important to note that these low prices are good for the economy as a whole. Individual consumers are benefitting directly due to the lower cost of gas. Companies that are big users of oil or its by-products see more profits going to their bottom lines.  However, energy-producing companies are being challenged by the lower revenue generated.

The following discussion is not meant to imply that the markets need higher oil prices.  Rather, it is meant to highlight potential investment opportunities that may be created by the low oil prices and what to think about before investing.

Why Oil Prices Declined

Prior to the summer of 2014, it was said with almost universal certainty that the price of oil would not drop significantly. If it did, it would only be a temporary drop before it went even higher. This played true as oil moved between $80 and a $100+ per barrel over several years.  Investors saw this trend play out and so did consumers.  You might remember the price of gasoline dropping for only a few days or weeks before moving back towards the $4.00 mark. That was the case until 2014.  

Without going into too much detail, new affordable technologies came on line that opened up formerly unreachable oil fields, particularly in the U.S. This added to the overall supply of oil.  In addition, China’s economy began to grow at a slower pace. China had been consuming a significant amount of commodities, including oil, as it built out its infrastructure. This slow down lowered the global demand. Greater supply and lower demand pushed the price of oil lower.  

As the price dropped, cracks in the oligopoly of OPEC became apparent.  Historically, the OPEC countries worked together to reduce overall oil production. This allowed the price to maintain high and their revenues to be maximized.  However, as the price continued to drop, oil producing countries became more concerned with maintaining their market share than reducing the global supply and, hence, production did not decline.

Is Now The Time To Invest?

The energy sector of the stock market was down more than 20% in 2015. Popular oil stocks, like Exxon and Chevron, continue to trade as much as 40% lower than their highs.  Investors might consider these prices to be a good deal.  
 
Is this the time to invest?  That depends on where the price of oil goes from here. If it continues to go down, the answer is no.  If the price of oil begins an upward trend, then an investment today may reap good appreciation in the future.

The price of oil is currently around $30 per barrel. While you may logically think $30 is way too cheap for a barrel of oil, that doesn’t mean the price can’t go down to $20.  After all, the price of oil has dropped over 70% in the past 19 months.  

How to Invest

If you believe now is the time to invest, you have several options. You can invest in the big oil companies, like Exxon and Chevron, which do exploration, production, and distribution. This diversification has helped to keep their stock prices from falling as much as oil, but they are still down significantly.

Another popular option for investing in the energy sector is an Exchanged Traded Fund (ETF), which is essentially an index of energy stocks.  A more complicated investment vehicle that may also utilize leverage is an Exchanged Traded Note (ETN) that invests in energy master limited partnerships. The leverage can enhance returns, both positive and negative; therefore, investors need to be very comfortable with the increased risk inherent in this type of investment vehicle.

Summary

As with any investment strategy, an investor must take a long term perspective. There is no shortage of pundits providing their opinion on oil. Take those with a grain of salt as virtually no one saw oil crashing from $100+ to $30 in 19 months.  You also need to have a strong stomach and a clear understanding of your risk and timeline.  As good as something may appear there are no guarantees.

Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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