Three predictions about the oil price

Making predictions about the oil price is a mug’s game, says David Thornton. But that's not going to stop him. So here goes with three of his own.


A lower oil price is good for consumers and the economy

The oil price has been grabbing the headlines again.

Since 2011, it's been trading at over $100 a barrel and hit a high of $125 during the Libyan civil war.

But in the last couple of weeks it's plunged below $70, and looks like it might settle in a new range which is approaching half the recent highs.

This is dramatic stuff. It's also very important for the world economy in lots of ways. And it matters a lot for stock markets, including the small company sector, which I focus on in my premium investment newsletter, Red Hot Penny Shares.

Even though there's a huge research industry dedicated to analysing and predicting movements in the oil price, making predictions is even more of a mug's game in oil than most markets.

I remember when the crude price hit $140 in the summer of 2008. Goldman Sachs called for $200 per barrel actually, the next stop was $35!

If the rather well-informed Goldman can be caught out extrapolating a trend to the moon, I'm not going to be tempted into sticking my neck out with specific forecasts. But I will make a few predictions.

Prediction no. 1: This low oil price could be here for a long time

I do think we can learn a lot by looking at the history of the oil price. The key point is that it's cyclical prices move up and down in long cycles.

The two oil shocks in the 1970s saw the price go from under $5 to $30 as the Opec producers' cartel took control of the market. Plenty of experts said it would go to $100 by the end of the next decade. But by 1986 it was back to $10.

Why the collapse?

As with any commodity, the oil price is a matter of supply and demand. A high price encourages lots of investment in new capacity. That same high price discourages demand we drive less, turn the lights out, and find alternatives.

So after a period of high oil prices we get more supply and less demand. You don't need to be an economist to realise this means a lower price.

The opposite happens when prices are low. Oil exploration projects get cancelled, and we become less concerned about our consumption habits. We buy more oil, and supply doesn't increase much; the market tightens and the price recovers.

If we ignore the short-lived plunge in oil during the 2008 financial crisis, we've been in a multi-year period of very high prices. This has caused the usual shifts in supply (up) and demand (not up by as much).

And lo and behold the oil price then suffers a fall big enough to change the behaviour of consumers and producers. So I think there's a good chance we won't see $100 again for some time.

But should we be happy about it?

Prediction no. 2: This is good news for the world economy

This is a movie we've seen several times before. And I much prefer it as an explanation of the oil price than the various conspiracy theories. Oil hasn't fallen because America wants to punish Russia, or because Opec wants to wreck the US shale gas industry!

Whatever the cause, a sustained lower oil price is clearly good news for the world economy. It acts like a giant global tax cut. We can already see it in the price we pay at the pumps. Spending £20 less filling up your tank means you've an extra £20 available to spend. And industry sees its manufacturing and distribution costs fall.

Remember: periods of high oil prices are associated with recessions (1974, 1980, 1990, 2008); while low prices help stimulate expansion. So don't believe those who tell you low oil is bad news because it must mean China is slowing down. It's actually very good news!

But what does it mean for oil and gas shares?

Prediction no. 3: This will probably be the final blow for the bear market in oil and gas stocks

Well as usual, the all-knowing stock market is ahead of the game. The oil sector has been underperforming since 2009. And it's a big part of the Aim market which is home to over a hundred junior exploration and production stocks.

Accordingly, it's a major reason behind the poor performance of Aim over recent years relative to other indices.

The recent era of high oil prices did what it's always done in the past: it sucked huge amounts of capital into the industry. Oil companies found funds easy to come by. Too much money was raised. Too many low-quality projects got financed.

This led to a lot of disenchantment with the sector and small oil companies have been struggling for a few years as a result despite a good oil price.

So if oil spends a sustained period of time around here we could see the final clearing out of the sector for this cycle. The industry will shrink and consolidate. Good quality survivors will become very cheap and the next bull phase can then begin.

As I said earlier, the market is already a fair way through this process; $60 oil might be what's needed to complete it.

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PS What do you think about the price of oil? Let me know your thoughts.

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