Oil price crash: a huge buying opportunity – but not yet

published 8 January 2015

150108-oil-price-crash — The oil price has further to fall - production costs are below $40 a barrel for most sources

Oil prices are continuing their epic slide. Brent crude even dipped below the $50 a barrel mark yesterday.

This is the sort of catastrophic price plunge that makes lots of investors nervy. Their brains are still anchored' to the pre-crash price. Regardless of what logic tells them, they still think oil is worth' $100 a barrel.

So they're watching a drop like this and thinking: "There are potential bargains here and I might miss them. I need to DO SOMETHING!!!"

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You might recognise this behaviour in yourself. I know I do. I'm only human, after all.

But don't fret. There will be big opportunities in the oil sector. But you'll have plenty of time to pick them up.

In the meantime, relax prices could be falling for a while yet.

The oil price wars aren't that different to the supermarket price wars

This oil price crash is entirely different. Slowing demand primarily from China has played a role. But as I've noted before, it's more about supply. US shale has added a significant new source of oil, and it has also arguably suffered from over-investment due to cheap-money fuelled enthusiasm.

So if there is in effect too much oil being produced, why won't the producers just stop making it? It seems the obvious solution.

But that's actually a daft question if you think about it. We only ask it about oil because we're used to the idea that it's a market controlled by a cartel.

It's like saying that Tesco's best response to the threat from Aldi and Lidl would be to stop selling anything. After all, the grocery market is clearly over-supplied. Knocking out the biggest supermarket chain in Britain would show those greedy, demanding consumers who was boss, eh?

But in reality, of course, it would hand control of the market to Tesco's rivals, and Tesco would rapidly go bust. The correct long-term strategy is to spend what it takes to slash prices, improve service, and hope your pockets are deep enough and your offer attractive enough to put the other guy out of business. Your shareholders might not be too happy about it it means falling profits, one way or the other but that's what happens when an industry hits a point of chronic oversupply.

The same logic applies to oil, believe it or not. That's why Saudi Arabia keeps saying in slightly hurt tones, I feel "why should we be the ones to cut production?" Why should they give up market share to Russia and US shale and all the other producers, particularly when they are the guys who are best-placed to survive any price war?

You can't give oil away for free. But we're not there yet

That's all true. And as the commodity team at Bank of America Merrill Lynch (BoAML) points out, the drop in oil prices will stop some projects from going ahead. But in terms of arresting the fall in prices, that's not enough.

You need production to fall. And the price hasn't yet fallen far enough to justify shutting down existing oil production.

Why? Because "operating cash costs" which is basically what it costs to get the oil out of the ground, or from under the sea, or extracted from the tar sands are below $40 a barrel for most sources. In fact, judging by a chart of costs, it's really only North Sea production that comes under threat at these prices.

So most wells remain profitable even with the oil price down by half. That means producers will continue to pump oil, and maybe even pump harder to try to compensate for the fall in price by an increase in volume.

It's not time to pile into the oil sector

I wouldn't be keen to start shorting oil from here, simply because the potential reward doesn't really outweigh the risks. If you're already holding a profitable short position, I'd hang on to it. But have a level in mind at which you'll take those profits if it rebounds.

But nor would I be piling into oil-related plays just yet. If you're still feeling jittery and eager for action, just remember that you don't have to catch the absolute bottom in these things to make money.

Another point is that despite the falls, oil is not necessarily a contrarian bet yet. Steve Sjuggerud of the Daily Wealth newsletter in the US notes that one of the key exchange-traded funds in the sector now has more shares outstanding than ever before. That means investors are piling in (which necessitates the creation of more shares). So the sector is not exactly hated.

I still think the best way to play the falling oil price is to get exposure to countries and sectors that will benefit from a lower long-term oil price. We've written about this regularly in recent issues of MoneyWeek magazine, and covered the topic in depth in our Christmas roundtable including a note on some of the stocks that will be worth buying when the oil price does finally turn around.

And if you're not already a subscriber, now really is the best time to do it you can get your first EIGHT issues free, along with a complete guide to sorting out your finances for 2015. This offer's only going to be around for a limited time, so if you've been thinking about taking the plungeand keep putting it off now's the time to dive in.

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.