We’ve seen the bottom for the oil price – time to invest

published 26 May 2016

160526-oil-price — Venezuela is struggling to maintain output

Yesterday, Brent crude hit $50 a barrel for the first time this year. It was last above this level in November last year.

It's partly because US oil inventories fell by a lot more than expected last week (4.23 million barrels, says Bloomberg, versus two million expected).

Meanwhile "attacks in Nigeria have cut the nation's production to the lowest in more than two decades and Venezuela is struggling to maintain output amid power cuts".

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Can oil keep up its winning streak?

Lessons from the oil market

Yet it seems not. Analysts were all over-optimistic when prices were above $100 a barrel, and then at the start of this year, they were all clamouring to call for $20 or less. And they were wrong.

Oil is such an important market, and it's anything but free. Production depends on many political factors, not all of them "rational" in the financial sense. Demand can be political too for building up stockpiles rather than consumption, for example. That's before you look at the impact of financial players betting on which way the price will go. So there are so many variables involved that it's pretty much impossible to account for how they'll all interact with one another.

But the trickiest part is this market feedback loop that I've talked about before. Prices which can seem very abstract when you're just idly looking at a Bloomberg terminal have an effect on real-world behaviour. And that behaviour in turn, affects prices.

When oil prices first started to collapse, no one could believe it. Then, in a short period of time, everyone thought that there would, in essence, be a never-ending glut of the stuff.

But the plunge in prices has hit supply a lot quicker than anyone thought. There are the predictable things, such as work on new shale projects in the US being cut back and the more extravagant big oil projects being abandoned. And then there are events that are down to sheer chance the wildfires in Canada, which have hammered supply from the tar sands, are essentially unpredictable.

But there also are events that analysts find harder to predict. Output is shrinking in Nigeria and Venezuela for example. That's because of militancy in Nigeria and the disaster zone of Venezuela's economy. Both of those things existed before the oil price crash Venezuela's economy was always a disaster in the making, for example.

But the dependency of each economy on oil meant that the oil price crash made everything much worse. That in turn, has affected each country's ability to produce oil. Nigeria, because of militants pressing the attack when the country's economy is weakened, and Venezuela, because power outages are harming production.

Chances are, we've seen the bottom for oil

But the fact that cutbacks are still happening does suggest that this rebound is sustainable. It's true that if prices bounce back, it becomes more feasible to restart production from certain shale fields.

However, the shock of the last two years is likely to make producers much more wary of taking on any sort of ambitious expansions plans. Most of them can't afford to they're still worrying about projects and projections that were made when a worst-case scenario for oil was $70 a barrel for onequarter.

Norwegian group Statoil now reckons that global crude supplies could "start to dwindle in as little as two years as the industry cuts investment to weather the worst market collapse in a generation", notes Bloomberg.

Says Statoil chief financial officer Hans Jakob Hegge: "For the first time in history, we've seen cutting of capex two years in a row and potentially we risk a third year as well for 2017". Royal Dutch Shell is slashing another 2,200 jobs this year just one example of the industry's mentality right now.

So while it's damn hard to predict exactly where the oil price is going, I think it's clear that we're on a path to lower production at a time when demand seems remarkably robust, despite all the fears over global growth.

It might not spell $100 oil any time soon, but I think you could make a very good case that we've already seen the bottom for oil prices and that if you haven't already bought into the sector, now is a good time to be thinking about doing so.

We've been looking at some of the best ways to play an oil rebound on several occasions in MoneyWeek magazine this year check out this recent article from my colleague Matthew Partridge, for example but clearly it's a topic we'll be returning to over and over again.

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John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John 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. John joined MoneyWeek in 2005.

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.