How to profit from the oil price rally

Exactly a year ago, the price of a barrel of West Texas oil was over $100. Even as late as early October, it cost $90.

Then, in the space of just over three months, the oil price halved to $45. At one point in March, it was just $43, a level not seen since the aftermath of the financial crisis.

Fears over a ‘cost of living crisis’ were replaced by concerns about sliding prices and deflation. Markets held their breath for a wave of oil-company collapses.

Yet since then, the price has rallied sharply. It’s back to around $60 a barrel. Sure, it’s not $100, but it’s a major rebound from the low.

That leaves us with two big questions: why is it happening? And will oil rally further?

The Saudi war of attrition on shale producers

One key factor driving oil prices lower last year was that the Saudi government ignored calls from other members of the Opec oil cartel to cut production. The Saudis didn’t see any reason why they should cede market share to their rivals. They could take the pain of lower prices. Others couldn’t.

They did this partly to hurt arch-rival Iran and its ally Russia. But it was also part of a long-term strategy to put US shale oil producers out of business. The rise of US shale oil is one of the biggest long-term threats to Saudi control of the energy market – in fact, last year the US overtook Saudi Arabia as the world’s largest oil producer.

The strategy seems to be working. Most of the major shale companies have cut back on exploration. Where firms have been slow to act, banks have forced them to do so by cutting their credit lines.

As a result, the number of working rigs in the US has fallen to 900. That’s down 50% on a year ago, and it’s the lowest figure for nearly five years. And the cuts aren’t over yet. Energy investor T Boone Pickens reckons the industry needs prices to rise sustainably to around $70 a barrel before firms stop losing money on every drop they take out of the ground.

Shale oil producers aren’t the only ones having problems – after the bonanza years and the lax cost controls they inevitably led to, everyone in the oil business is feeling the squeeze.

Staff costs are being cut. Around 75% of North Sea oil producers have shed staff and reduced working hours. Investment in equipment is on hold – all the major global oil companies have cut capital spending.

And exploration budgets are being squeezed. Energy analyst Wood Mackenzie reckons they will fall by an average of 30% this year. These spending cuts will not only hit today’s production levels, but will also reduce supply for years to come.

The ever-present tension in the Middle East

The other reason for oil prices inching higher again has been rising tension in the Middle East. For the past two months, Saudi Arabia and Iran have been fighting a proxy war for control of Yemen. The situation is complicated, since there’s also a third faction, which is allied to Al Qaeda.

However, it boils down to this: Iran is backing the Houthi rebels, which now control most of the country. At the same time, a Saudi-led coalition is taking direct action to defend the official government.

While there has been a temporary pause in fighting, few expect it to hold. Houthi forces have begun attacking Saudi towns on the border between the two countries. Meanwhile, there are reports that Saudi ground troops are about to enter Yemen. Experts warn this could lead to a wide conflict between the Middle East’s two main powers that could end up disrupting oil supplies.

Won’t production just start up again?

Can the rally last? After all, a few days ago, Goldman Sachs released a report arguing that prices may start to fall again as US producers are tempted back into the market. Julian Jessop of Capital Economics agrees: “prices are now more likely to fall than to rise over the remainder of the year”.

However, this may be overly hopeful (or pessimistic, depending on whether you’re an oil producer or consumer). While some shale oil firms can make money if prices move above $60, others need $70-$75, or even more, if they are to remain profitable. The momentum may remain with cutting back, rather than re-entering the market.

At the same time, there is evidence that China’s growing stimulus efforts (it cut interest rates again at the weekend) are boosting its demand for oil. Even if the price doesn’t surge from here, it looks like the low may be in at least.

We wrote about how to play the oil sector in MoneyWeek magazine a month or so ago. Subscribers can re-read the piece here – and if you’re not a subscriber, you can get your first four issues free here.

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