Oil prices are heading lower – here’s how to profit

published 13 June 2012

So much for the Spanish bail-out.

As we noted on Monday, the key problem with Spain's €100bn loan from Europe is that it is likely to push other creditors down the payment queue. Periphery' bonds might have been toxic before the bail-out, but they're even worse now.

With that in mind, everyone is now focused on how badly the Greek election might go at the weekend. It's all rather unnerving.

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But all of this concern over the state of the global economy has had one beneficial side effect the price of oil is falling. That's good news for almost everyone, except producers of oil.

However, with oil cartel Opec meeting to discuss production tomorrow, can the oil price continue to fall?

How much influence does Opec really have?

The Opec meeting promises to be an ill-tempered little get-together. As the FT points out, it "occurs against the backdrop of the biggest monthly fall in oil prices in four years".

Saudi Arabia wants to keep production high, or even raise it; Iran and Venezuela would rather cut back to bolster prices. Normally, with prices falling sharply, you might expect the argument for cutting to win out.

But the global economy is looking very fragile, and the Saudis in particular are smart enough to realise that if high oil prices derail any sort of recovery, then demand will fall, and they'll end up facing lower prices for longer. Better to keep prices at high but bearable levels than to break the backs of your customers entirely.

More importantly, if you keep prices too high, it encourages your customers to search for alternative sources of energy.The development of natural gas and oil shale is already past the point of no return; the last thing oil producers want is a genuine breakthrough energy technology like solar to take off.

Indeed, as Julian Jessop at Capital Economics points out, earlier this year the Saudi oil minister, Ali al-Naimi, had been arguing that oil prices were too high; in his view, $100 a barrel was a better level to "balance the interests of producers and consumers".

There's also the desire to "keep the market well-supplied" before tougher sanctions are put in place against Iran at the start of next month. On top of that, "Opec would not want to be seen to kick the global economy when it is down".

So chances are nothing will change tomorrow. What does that mean for the oil price? The truth is, almost certainly very little.

As Jessop notes, "the important point is that Opec is not all-powerful. The cartel was presumably far from happy when oil prices fell below $40 in early 2009 and yet there was little it could do in the face of collapsing demand and soaring risk aversion."

Arguably, the most important factor in the plunging price this month has been financial. The global economy has been slowing for months, and oil supplies have been plentiful for some time. Indeed, the US is sitting on more oil than at any point since 1990, according to Bloomberg, at a time when demand is close to a 15-year low.

The argument has been that fear over Iran has kept the price high. Yet it's only now that the market has been spooked by Europe that oil prices have come down. That's been reflected in the number of long' bets on the oil price. According to the FT, in just two weeks last month, "money managers reduced their net long speculative positions for Nymex oil contracts by 34%, the largest amount on record".

Now, people will argue until they're blue in the face that oil speculation' has no significant impact on prices. You can find research papers that support either side of the argument. My view is that oil is no doubt like any other market - in the very long run, it probably reflects supply and demand fairly well, but in the short run, it's as prone to manic mood swings as any other.

In other words, oil's fall is mainly because it is just another risk-on' trade that has been sold off as investors start to panic about the state of the global economy. So will the sell-off continue?

How far could oil prices fall?

I suspect it will. As Bloomberg puts it, "with speculative money pouring out of the oil market, the price is closer to reflecting supply-demand fundamentals". If that continues to be the case, then oil prices "should continue to fall through the summer." According to Fadel Gheit, oil and gas analyst at Oppenheimer, "if you remove the speculators, supply and demand fundamentals support oil prices at barely $80."

Yes, if there's a big eurozone bail-out or the Greek elections go better than anyone expects, then it might bounce along with every other risk-on' asset. But now that the jitters are setting in about the state of the global economy, the path of least resistance for oil is lower.

If you want to profit directly from a falling oil price, you could try spreadbetting (which is extremely risky see our MoneyWeek Trader emailfor more on tricks and tactics for improving your chances of profiting), or you could buy an exchange-traded fund that rises as the oil price falls.

The ETF Securities Short WTI Crude Oil (LSE: SOIL), is a slightly less high-octane option for betting on a falling oil price, but make no mistake - it's still a speculative punt at the end of the day. It's gained about 16% over the past month. Do remember that this fund is rebalanced daily so if you hold it for long, and the price doesn't go straight down, it may diverge from the underlying oil price performance rapidly.

For longer-term investors, I still think the best bet in the energy sector is to focus on companies in the natural gas area. Natural gas is so much cheaper than oil that it makes sense for users to change their habits. We last covered natural gas here: Don't write off natural gas - the smart money is buying nowand we'll be returning to the topic regularly in the coming months. It also makes oil and gas major BG Group (LSE: BG) an interesting stock to put on your watch list.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.