The oil market is showing signs of life again

Most markets have had a tough time of it during the coronavirus pandemic.

But few can compare to oil. Even if you discount the plunge to negative levels seen in one high-profile contract last month, the slide in the oil price has still been dramatic.

However, the market has once again proved that prices shape behaviour as much as behaviour shapes prices.

And oil is bouncing back as a result.

Oil demand has collapsed – but so has supply

The International Energy Agency (IEA), a Paris-based energy industry body, reckons that oil production is set to hit its lowest level in nine years this month, at 88 million barrels a day. That’s a big turnaround in a very short space of time.

Just a few short months ago, the major oil producers embarked on a brutal price war. Saudi Arabia and Russia – the duo commonly now known as Opec-plus – had a bit of a falling out, and also fancied their chances at putting those pesky US shale drillers out of business.

So they both pumped as much oil as possible with no care for the consequences. Indeed, last month, Saudi Arabia's oil production hit a record high.

Of course, this happened just as the entire developed world was on the verge of shutting itself down to dampen the coronavirus pandemic. No planes, hardly any cars, very little industry – globally, oil demand fell off a cliff.

The various participants tried to brazen it out. But by the middle of April, everyone involved was starting to feel the pain. Russia and Saudi Arabia might be able to produce oil very cheaply, but they both need to make big profits on the stuff they pump out in order to support their public spending commitments.

To put it another way, both Saudi Arabia and Russia require a high oil price to maintain economic and therefore political stability. Low oil prices represent a risk to domestic harmony. And no authoritarian government is keen to push the people too hard when it comes to that.

So everyone involved in oil production is now scrabbling to slash the number of barrels being pumped out. The US shale producers and Canadian tar sands producers have been cutting back on spending and exploration plans, and shutting down existing wells. The number of active drilling rigs in the US is at its lowest in almost five years.

Meanwhile, the Saudis have made even deeper cuts to their own production than they had first planned, announcing an entirely voluntary extra cut a couple of days ago, a move which was followed unexpectedly by Iran.

This has offset the initial scepticism markets had about whether oil producers – a notoriously unco-operative bunch – would actually stick to their promises.

It also helps that, according to the IEA, demand is not going to be quite as bad this year as it had previously expected. It’s still fallen pretty dramatically (to an estimated 91.2 million barrels a day, compared to 100 million a day last year) but it had originally expected an even greater drop.

As a result of all this, the oil price (as measured by Brent crude) is challenging the $30 a barrel mark once again, having hit an 18-year low of less than $20 a barrel just last month.

The oil majors are probably safe-ish bets for now

What can investors pick up from this? It’s another lesson to watch out for extremes in markets.

When oil prices turned deeply negative at the end of last month, it was a shocking event. It’s true that it only happened in one specific contract, and for one specific benchmark (WTI crude) and that it happened for very unusual reasons (overflowing storage tanks, basically).

But it was a headline grabber – even the non-business papers tried to cover it, with varying degrees of success – and that’s often a good sign that you’re in solid territory for taking the “contrarian” view.

When everyone is talking about how a market can only go in one direction (we even had predictions of oil hitting negative $100 a barrel), then the odds are good that you should take the other side of that trade.

Why? Because markets aren’t a one-way street. The slide in prices was caused by a change in the behaviour of Saudi Arabia, Russia, and the global population. One side pumped even more oil, the other side stopped consuming it.

But this same slide in prices caused behavioural changes too. On the demand side, people can’t buy more petrol right now simply because they’re in lockdown. But governments have been picking up more for their strategic reserves.

More importantly, on the demand side, producers realised that contrary to their earlier hopes, they simply couldn’t sustain a drop as drastic as the one they’d helped create. So they took action to reverse it.

Commodity markets are typically where you see this cycle play out most obviously. High prices lead to overproduction, which leads to low prices, which leads to underproduction, which leads to high prices, all with a predictable lag that mostly depends on how hard it is to shut down or open up production.

(This, incidentally, is why I’m always moaning on about how central banks have too much influence over market prices. If you distort the pricing mechanism then you gradually blunt the purpose of markets. They become mechanisms for handing out money to cronies, rather than funding and boosting smart competitors. You almost end up with a sort-of patronage economy rather than a free market one.)

Anyway, that’s a discussion for another day.

If we've now seen the bottom for oil prices then that suggests that the big oil majors are safe enough to stick with. Royal Dutch Shell (LSE: RDSB) has already cut its dividend, so that’s probably the UK-listed one with the least chance of more nasty surprises. That said, you could probably be fine with BP (LSE: BP) too as long as you brace yourself for the inevitable dividend trim later this year.

Meanwhile if you’re on the lookout for dividends, you should definitely get hold of this week’s issue of MoneyWeek magazine, out today. We look at some of the best options to grab an increasingly-scarce income from markets today. If you’re not already a subscriber, what are you waiting for? Get your first six issues free here.