Oil was my 2016 “trade of the lustrum” – but should you keep holding on?

Oil workers © Getty Images
The US produces more oil than both Saudi Arabia and Russia

This article is taken from our FREE daily investment email Money Morning.

Every day, MoneyWeek's executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.

Sign up free here.

Today we take a look at oil.

It may be the most important fuel in the world, but, as far as the price is concerned, gravity has taken hold.

It has, this past month or so, fallen off a cliff, as they say. And it continues to fall.

Today we consider they whys, the wherefores and the what nexts.

What’s behind the oil price slump?

From just shy of $87 a barrel at the beginning of October, Brent touched $58 on Friday, meaning it lost about a third of its value. It is currently sitting at $61.

West Texas Intermediate (WTIC) did something similar, falling from $77 to $50 a barrel. It’s currently sitting at $51.

One always likes to know why these kind of moves take place – I often think the reason gets tacked on afterwards to make sense of the narrative. Nevertheless, the generally accepted reason for this current move boils down to perceived excess supply.

A month ago there were fears that US sanctions on Iranian oil exports would mean a loss of something like a million barrels a day (bpd) to global supply. $100 oil was coming, they said.

Then the US issued sanction waivers for eight countries importing Iranian crude. US production hit record highs – the US now produces more oil than both Saudi Arabia and Russia. And, with stockmarkets, and thus economies, generally perceived to be weak, the forecast was that demand is going to tail off as well. In short, global markets are amply supplied.

US president Donald Trump, meanwhile, has taken the credit for the move, which is most unlike him, proclaiming: “So great that oil prices are falling (thank you President T). Add that, which is like a big Tax Cut, to our other good Economic news.”

To be fair, he had been having a go at oil cartel Opec over high oil prices for many months, and the sanction waiver does appear to have been a major trigger for the change in direction of the oil price. Lower prices were what he was gunning for.

He is now urging Saudi Arabia not to cut its production, but it seems Saudi Arabia will, nevertheless, in an effort to stabilise prices, cut its own output by around 500,000 bpd, and urge other Opec nations to do the same.

How far will oil fall this time?

Oil seems to experience these violent sell-offs every few years. I still remember 2008 like it was yesterday. Oil had been in a bull market for nearly ten years that took it to almost $150 a barrel. Within six months, it gave back five years of gains and touched $36.

2014 saw another epic sell-off, now known as the Great Oil Bust. Brent had traded for around three and a half years, mostly in the $100 to $125 range. These kind of levels looked like the new normal.

Then, not unlike now, president Barack Obama lifted US sanctions against Iran, US shale production surged and there was lower-than-expected global demand. Oil went from $115 to $45, bounced and eventually hit $27 a barrel in early 2016, an extraordinarily cheap number.

Here are 15 years of Brent, so you can see the action.

Brent crude oil price chart

In early 2016, I called buying oil “the trade of the lustrum” (a lustrum is a five-year period. It’s an almost criminally underused word).

Oil was $33 and our advice was to buy, hold and forget. Prices would go a lot higher, and they did.

Our main vehicle for buying oil was not the usual suspects BP (LSE: BP) and Shell (LSE: RDSB), but BHP Billiton (LSE: BLT). Even though BHP is known for mining, oil is its biggest product and it tracks the oil price well – better, bizarrely, than BP, Shell or the iShares oil and gas exploration and production ETF, (LSE: SPOG).

BHP has actually held up very well in the face of this sell-off, currently sitting above 1,500p (we recommended it at 700p). BP, Shell and SPOG – our other suggestions – are now in downtrends.

So the question now is, how far is the oil price going to fall?

I rather suspect this sell-off is going to be more like those of 2004, 2006 or 2012, rather than the monsters that were 2008 and 2014-15. That is just a feeling, by the way, a hunch – it’s not based on any detailed analysis of oil supply-and-demand statistics.

But you do get a feel for the way a particular market trades the more you watch the price.

I’m projecting Brent to make a low in the $45-$55 range. Thus I’m not sure this sell-off is quite done yet, although a bounce is probable.

If Brent goes to $45 I think there is a real opportunity there and I’ll almost certainly be looking to load up. Shell, at this point, is the one I really have my eye on, as well as BP. Dividends and all that. If they carry on declining and BHP holds, that is where the greater value might be.

Short-term traders might even be eying BHP as a short, given the fact it has held up where others have fallen. Not for me that one, but I can see the argument.

As for the trade of the lustrum. This was a long-term trade with a five-year horizon. We are two and half years into it. Given oil went from $33 to over $80 there was a good argument to be taking profits up there.

But if you sell now, will you be sure to buy back at lower prices? Will we even see lower prices?

Questions, questions, questions. Buy, hold, forget was the strategy. So we stick with it.

disfi.com