We need to see some carnage before the oil sector bottoms out

By John Stepek

published 8 December 2015

in Features

151208-opec — The latest Opec meeting wasn't a happy gathering

Forming a cartel sounds like a great idea.

You get to control the supply of something that lots of people need. That means you can charge what you like for it.

Genius! No wonder most countries have rules against monopolies.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

There's a problem though: if you're greedy, and you get comfortable with high prices, then at some point, you squeeze your consumers so hard that they make the effort to find alternatives.

Once they've done that well, your little cartel might find itself under pressure. The comfortable relationships that existed when everyone was enjoying high prices might start to fracture when prices fall.

As you'll have guessed by now, I am talking about oil cartel Opec. And I'm finding it difficult to feel an ounce of sympathy for the rather tricky predicament they find themselves in.

But it does have a knock-on effect for investors. So let's have a look at what's going on.

Opec - the least cuddly cartel in the world

According to the FT, Opec representatives left the meeting "visibly angry", "shunning questions", or with a "blank stare". Journalists actually laughed out loud when the secretary general tried to convince the assembly that it was a productive meeting.

Basically, they "could not agree a new target even on paper", showing that "Opec has abandoned any pretence of acting as a coherent group".

It's not surprising. Saudi Arabia, the biggest producer, would have to cut production if it wanted prices to rise. But the problem is, if it cuts production, it just leaves a gap in the market for rivals Iran and Iraq (as well as the smaller desperadoes in the cartel). And it also leaves a gap for non-Opec members such as Russia which doesn't care quite as much about the falling oil price, because in rouble terms, the price hasn't fallen by anything like as much.

If Saudi Arabia caves, then it's the equivalent of Tesco deciding not to sell Christmas puddings. It wouldn't drive up the price it'd just mean that other people would sell more Christmas puddings.

Hence the plunge in the oil price. It's every man for himself out there. In fact, it's almost as if there is no oil cartel at all.

So what does that mean for oil prices?

Story-telling can be dangerous for investors

Investing is all about stories. In fact, human life is pretty much all about stories.

We are pattern-detecting creatures. We look for patterns to help us make sense of the world. At its simplest level, detecting a pattern allows us to make a prediction about what will come next. Cause and effect. In turn, that enables us to avoid harmful actions and pursue beneficial ones.

Human beings also crave certainty. But we live in an uncertain world. Patterns help us to create the illusion of certainty in this uncertain world. And that illusion of certainty is often more important than reality that's why it's so hard to challenge or change another person's cherished beliefs, regardless of how clearly wrong they are.

Of course, one problem is that we often spot patterns where none exist. And this happens in investing all the time. Investing is an activity where the stakes are high (money and our dreams of future wealth) and our level of knowledge is necessarily tiny (we're just one of a multitude of participants in the market). So our pattern-spotting mode goes into overdrive.

That's why investing and a good story go hand in hand.

So here's what happened: the oil price kept going up and up, and up. We had a global financial crash, and the oil price collapsed briefly as demand across the globe literally dried up.

(You may or may not remember, but we were at a point where container ships couldn't traverse the planet because the payment and credit system that made sure people got paid for their cargo was under existential threat.)

But then China printed a load of money, and the oil price came back. And it just kept rising. It didn't seem to matter that US shale producers were pumping out oil. It didn't seem to matter that the oil majors were sticking drills in places they'd never stuck them before. Rising fuel efficiency made no odds. That oil price just stayed wedged above $100 a barrel.

Hence, we had a story in the making. The oil price isn't responding to rising supply, so it must be down to oil cartel Opec keeping prices high. And from there, it's an easy step to assume that "well, Opec won't let oil prices fall below $100 a barrel". That was the statement on the lips of every oil analyst just a short 18 months or so ago.

Turned out to be nonsense of course.

Once again, we learn that the cure for high prices is high prices

The rather wonderful financial historian and analyst, Edward Chancellor, has written a piece in this week's MoneyWeek magazine about the capital cycle' and gold miners. The piece looks at why now is a good time to buy gold miners. We've also got a few tips on which ones to buy (sign up for a subscription to read it now if you've been thinking about getting MoneyWeek for a while, this is a really good place to start).

But the key point is not gold miners. It's this point about the capital cycle'. Chancellor points out that in almost every industry not just the chronically disappointing gold mining business rising prices lead to rising supply, which eventually leads to oversupply and collapsing prices.

And that's what's happened to oil. High prices created the US shale industry. That was aided and abetted, of course, by the flood of quantitative easing and the hunt for yield. Investors were happy to fund a boom industry on the cheap, which is arguably one of the only things that made the US shale boom possible in the first place.

And now, even although shale producers are running into financial trouble, the infrastructure and the industry is in place so that if oil rises above a certain level, it'll be much easier for shale producers to switch the taps back on, as it were. So arguably, the oil price is now capped for the foreseeable future.

Merryn and I talked about this in more depth on the latest MoneyWeek podcast.

But the long and the short of it is that we can expect the oil price to be lower for longer'. And my gut feeling is that until we see some proper carnage in the corporate sector (we're on the way there, the amount of distressed debt in oil and gas is picking up fast), we won't see things bottom out.

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.