Oil price war: Profit from the battle for black gold

The oil price is falling dramatically but there's further to go.John Stepek explains why, and how you can profit.

When we last wrote about oil, less than two months ago, the price was on the slide, and Saudi Arabia was making noises about being comfortable with oil at around $80 a barrel. We suggested that prices could go a lot lower, and since then, they have.

Brent crude is now sitting at around $70 a barrel. And suddenly everyone's talking about it. But the price could fall further still we reckon it'll be a good while before we see the $100 a barrel mark again. Here we'll explain why and how you can profit from it.

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The facts the ones that really matter to investors are pretty straightforward. Weakening demand for oil has played a bit of a role, but the main reason for the sliding oil price is that production in America has grown sharply while various bottlenecks in other parts of the world have been cleared.

The latest development emerged from a meeting of oil cartel Opec last week. The group which controls around 40% of global oil output held production at its current target level of 30 million barrels per day.

Some members were clearly unhappy about this Iran and Venezuela, who each require a $100-plus oil price to balance their national budgets, were among the most vocal. But Saudi, the biggest producer, is unwilling to cut production and so sacrifice market share to its rivals, particularly when it is the best-placed Opec nation to withstand a period of cheaper oil.

Why did Saudi decide to do this? Some argue that Saudi wants to put the US shale oil producers out of business to make the industry unprofitable.

Others argue that Saudi is conspiring with the US to hurt Russia (which supports many of the regimes Saudi doesn't like) and Iran (which is one of the regimes Saudi doesn't like).

Most likely, the Saudis are aiming to make the best of a bad situation at the end of the day, history shows they have far less control over oil prices than is popularly believed. Keeping on pumping means the cash keeps rolling in and there's a chance they could kill two birds (the frackers and their political rivals) with one stone by helping prices to find their natural' balancing point.

As Amrita Sen, oil analyst at Energy Aspects, put it in the Financial Times: "This is becoming a battle of the deepest pockets and survival of the fittest."

The frackers will keep on drilling

However, if the Saudis hope that US shale producers are going to stop drilling anytime soon, they'll have another think coming. As energy consultant Daniel Yergin puts it in The Wall Street Journal, at these levels, companies will be looking to cut or delay their investment plans. "But it will take time for these decisions to affect supply. US oil production will continue to rise in 2015."

According to a study by energy analysts IHS, about 80% of tight-oil' production will be economic at prices between $50 and $69 a barrel. According to the International Energy Agency, the average cost per barrel in North Dakota is just $42. In certain areas, it gets as low as below $30.

This is, of course, still bad news forshale producers and oil companies.They might be able to pump profitably, but they won't be making as much money. And it's bad news for oil services companies Schlumberger, the world's biggest oil services group, has this week taken an $800m write down on the value of the ships it uses to do offshore geological surveys, for example.

Share prices in the sector have plunged accordingly. Are there any bargains available? We suspect there will be but only eventually. The trouble is, the oil price could fall a lot further before it stabilises'. As Yergin points out in The Wall Street Journal, American oil production has risen by 80% since 2008, to nine million barrels a day.

This "increase alone is greater than the output of every Opec country except Saudi Arabia". That's an extraordinary addition to global supply. And it isn't unprecedented. As Yergin notes, in the early 1980s, "a surge in oil from the North Sea, Alaska's North Slope and Mexico", combined with a "deep recession", saw oil prices plunge to $10 a barrel.

Last week, one oil tycoon Canadian Natural Resources boss Murray Edwards declared that oil could fall as far as $30 a barrel. Now that sounds like the sort of epic bottom-of-the-market call that often signals a turn.

However, he followed it up by arguing that prices would then stabilise around the $70 mark a convenient sort of figure at which most alternative sources of oil would still turn a profit. So we wouldn't take that as a contrarian buying indicator it's stilltoo optimistic.

The point is that oil prices are likely to stay lower for longer than anyone might expect. That's bad news for companies and countries that depend on oil Russia is heading for recession, for example but it's great news for countries that aren't addicted to oil.

And it's great news for companies who serve consumers who won't have to spend as much money on petrol, for example.

As Andrew Kenningham of Capital Economics puts it: "each $10 fall in the oil price represents a transfer of annual income of around $330bn, or 0.4% of world GDP, from oil producers to oil consumers".We look at some of the best candidates and update on the ones we tipped last time in the box below.

This all sounds pretty cheerful. We get cheaper energy, some of the world's least-pleasant regimes lose their bargaining chips and much of their revenue good news all round. But there are a couple of caveats potentially quite big ones.

Firstly, there's the issue of political risk. There's the question of whether or not a lower oil price could destabilise Russia, or encourage it to escalate its aggression in an effort to distract from problems with the economy.

Meanwhile, the Arab Spring protests that started in late 2010 were avoided in certain countries partly by bribing the populace with oil revenues. Falling revenues could make popular unrest harder to avoid.

Secondly, there's an outside chance that the sliding oil price could trigger the next major financial crisis. Why? Energy junk bonds (also known as 'high yield').Before we explain why, it's worth remembering that in the past, big financial blow-ups have often begun in relatively obscure parts of the market.

For example, in 1998, it was Russia's default that went on to trigger the collapse of the Long-Term Capital Management (LTCM) hedge fund, which had to be bailed out in a hurry by Alan Greenspan's Federal Reserve.

And in 2007 the troubles of subprime mortgage lenders were still being seen as an easily containable problem. So while energy junk bonds might sound obscure, that doesn't mean they couldn't end up being a problem.

So why do they matter? Right now, energy junk bonds are one of the biggest sectors in the high-yield market. Oil companies have been cheerfully raising cheap money from investors willing and eager to invest in anything with a half-decent yield. They account for around 16% of the market, from just 4% about ten years ago. That's a big chunk of the index.

Unfortunately, as Deutsche Bank points out, if the oil price goes to $60 a barrel or lower, and stays there, most, if not all, of that debt could end up being "distressed" ie, priced as if it's going to default.

Already prices have fallen sharply for a very visible example, a bond issued on London's retail bond market (targeting private investors) by Aberdeen-based oil explorer EnQuest has seen its face value drop by around 30p in the last few months.

Not all of these bonds will end up in default, of course. But the number of companies going bust will be a lot higher than in the recent past. And what happens then? As Joshua Brown of the Reformed Broker blog notes, trader James Farro at Signalinea has a worrying but plausible theory.

If rising defaults in this market trigger a general exit from junk bonds which it might, given that larger numbers of investors have been buying junk bond indices and won't discriminate when they sell then it'll get a lot more expensive for companies to raise money, because yields will spike.

The trouble is, a lot of money has been raised to pay for share buybacks. In fact, by some calculations, share buybacks are largely what has kept the market rising in recent years. So quite apart from the panic caused by a spike in junk bond defaults if buybacks are brought to a shrieking halt as a result of borrowing costs rising, we could see the stockmarket fall too.

Of course, if this all pans out, the chances are that the Federal Reserve will start printing money again to offset any domino effect it's become a trusted part of the central banking toolkit. But not before the market has taken a serious hit. And bear in mind that this market is a tougher one for the Fed to act on.

It's one thing to prop up banks and governments by printing money to buy government bonds it's quite another to prop up politically important oil producers by printing money to buy crude (yes, it seems far-fetched, but so did the idea of printing money a few years ago).

The scenario may or may not pan out. However, we'd be very wary of holding high-yield debt right now. After all, regardless of what happens, there are tough times ahead for one of the biggest sectors in that market, and it's arguably overpriced in any case.

And we'd certainly make sure to keep holding exposure to physical gold in your portfolio, just in case another financial crisis does erupt.

The five stocks to buy now

As Sam Vecht of BlackRock tells Bloomberg, a "portfolio that works well with oil priced at $110 oil is not the same portfolio that works at $70". By that, he means it's time to get exposure to countries that are "net energy importers", rather than large exporters, such as Russia. We mentioned India and Japan last time (see the updated tips below).

Another potentially good option is Turkey, which imports most of its energy. As Turkish finance minister Mehmet Simsek told Bloomberg: "It's great, not good, absolutely great. There are very few countries that benefit significantly, and Turkey is one of them."

Turkey has a hefty current account deficit (in other words, it relies on attracting foreign cash), but sliding oil prices could see that fall to below 4% of GDP next year from almost 10% of GDP in 2011. The country has also benefited from hostilities between Europe and Russia Turkey doesn't support the annexation of Crimea, but nor is it involved in sanctions.

As a result, it has landed a 6% discount on natural gas prices from its neighbour. If you want to invest in Turkey, there's an exchange-traded fund (ETF) that does the job iShares MSCI Turkey (LSE: ITKY) for an annual total expense ratio (TER) of 0.74%.

China is also worth buying. We've liked China for a while now it's been one of the best-performing markets of this year but the drop in oil prices gives another good reason to buy in.

China is the world's biggest oil importer. And while the slump isn't as significant as it might be in some other nations (as the FT reports, "the state-set pricing formula means consumers see little additional savings when the price drops below about $80 a barrel"), it's still helpful at the margins.

There are several ways to buy China you can opt for one of several ETFs, such as the iShares China large cap UCITS ETF (LSE: FXC) (also on a TERof 0.74%). Or you can use an investment trust such as theJP Morgan Chinese investment trust (LSE: JMC).

The TER is 1.24% and it currently trades on a discount of 6.9% (that's a little more expensive than normal, but it reflects the solid performance of the market this year).

Another beneficiary overall could be Europe. Why? Because a drop in oil prices will lower the inflation rate. While central bankers tend to ignore energy price-driven inflation, thethreat of the inflation rate turning negative even on asimple headline' measure in the eurozone, might be whatit takes to get European Central Bank (ECB) boss Mario Draghi to embark on full-blown quantitative easing (QE), says Andrew Kenningham of Capital Economics.

QE, as we've noted before, tends to drive share prices higher. One of our favourite eurozone trades has been Italy the iShares FTSE MIB ETF (LSE: IMIB) is a straightforward way to play it.

On that note, of course, there's also the danger that falling oil prices will give central banks the excuse they need to ignore growing inflationary pressures which is another reason to hang on to your gold.

We suggested some consumer stocks that might be beneficiaries in the last issue and we've updated on them on the following page. But if you're in the market for a contrarian punt on lower oil prices, it might be worth looking at the supermarkets.

They are engaged in their own price war just now, and their share prices have taken a hammering accordingly. But falling petrol prices mean more money to spend in the shops, and also mean a lower deliveries bill for logistics-intensive companies. Of the three big UK ones, we'd say Sainsbury's(LSE: SBRY) is probably the grocer in the best condition.

Oil tips update

Back in mid-October we tipped several ways to profit from the falling oil price.Since then, the short crude oil ETF, ETFS Daily Short WTI Crude Oil (LSE: SOIL), has returned around 20% in sterling terms. We suspect oil could yet go a fair bit lower, so it's worth holding on to if you've held it so far. Just remember that this is a short-term trade, so keep an eye on its performance.

The Aberdeen New India Investment Trust (LSE: NII) is up about 18%, and we'd hold on to that. We'd certainly stick with Japan Baillie Gifford Japan Trust (LSE: BGFD) is one of our favourite ways in (see page 21 for more on this). Consumer staples providers such as Nestl (Zurich: NESN), Unilever (LSE: ULVR) and Reckitt Benckiser (LSE: RB) have lagged the market, but we'd stick with them.

Airline easyJet (LSE: EZJ) is up around 16%; cruise operator Carnival (LSE: CCL) is up 22%, and tour operator Thomas Cook (LSE: TCG) is up 10%, despite the recent turmoil (see page 13). We'd hang on to all of them. Logistics giants United Parcel Service (NYSE: UPS) and FedEx (NYSE: FDX) have also jumped strongly.

The only real dud has been shale play US Silica Holdings (NYSE: SLCA), which is down a painful 37%. The market is clearly concerned that its business providing sand for fracking wells more efficiently will dry up if fracking does too.

It's one to watch as a potential recovery play, but if you haven't bought it yet it probably makes more sense to wait for signs of the oil price stabilising.