Why oil stocks still look like a good bet

Oil is at its highest price for more than two years. And with demand recovering while supply remains constrained, it all looks good for oil stocks, says John Stepek.

Yesterday, Brent crude oil hit the $75 a barrel mark for the first time in more than two years.

It’s a far cry from the depths plunged just over a year ago. Brent never turned negative (unlike the US benchmark) but in April last year, you could’ve had yourself a barrel for less than $16 (we’ll ignore the question of where you could’ve stored such a highly toxic gift).

So what’s next?

What’s next for the oil price?

As Dominic pointed out last week, commodities have been having a tougher time of it in recent weeks. The Federal Reserve’s somewhat hawkish turn didn’t help on Wednesday. But it was going on before that.

However, one commodity stands out for its staying power: oil. Oil is the most important publicly-traded commodity (water matters more, but you can’t easily trade it – please, no jokes about illiquidity, it’s too early in the week).

Brent hit rock bottom in April last year. It then rallied strongly until June. We then had a more gently rising trend during the excitement of temporary re-opening. Then a period of flattening misery as Covid just kept on coming.

Then in November, we got news of the vaccine and the price surged into the end of 2020 and didn’t really stop until March, when it took a breather after breaching the $70 a barrel mark. We saw a brief retreat below $60, and then it took off again near the end of the month and has steadily ticked higher ever since.

Now, I wouldn’t be at all surprised if oil prices take a break for a bit. There’s the simple reason that prices don’t go up in straight lines, for one thing. There’s also the concern that it’s an inflation trade which hasn’t yet buckled under fear of the Fed.

And then there’s the surefire contrarian indicator which is analysts starting to make cocky forecasts. Bank of America suggested yesterday that oil might hit $100 a barrel in 2022, which is – according to Bloomberg – “the strongest call yet among major forecasters for a return to triple digits”.

Don’t get me wrong, that’s not a showstopper – if he’d said $200 I’d be thinking it was the end of the line – but it’s just a sign that there’s a bit of exuberance in there that might need deflating.

Of course, none of this really matters unless you’re daytrading oil, and as I always say, if that’s what you’re doing then I can’t help you, other than to recommend that you don’t.

Supply is recovering while demand is being held back

However, beyond a bit of bumpiness I’d expect oil to stay around these levels or go higher. You’ve got demand recovering and you’ve got people likely to be driving more during the summer (particularly in America).

On the supply end, you’ve got the Opec+ cartel (that is, Russia and the Gulf countries) being surprisingly disciplined. That could well change.

But beyond that, you’ve got lots of pressure on most of the listed oil majors to “go green”. That is going to crush investment on any sort of marginal project.

Similarly, the fracking industry in the US shale fields has also apparently learned from the boom and bust years, and has now imposed capital discipline.

As Bloomberg reports, these companies are actually generating cash flow now as opposed to burning through investors’ money. That’s at least partly because they have held back on new supply. “They’re saving cash instead of spending money to ramp up output at all costs.”

All in all, US oil output has dropped by around 1.9 million barrels a day compared to its pre-Covid peak. Notes Bloomberg again, that’s like knocking both Nigerian and Venezuelan production out of the market.

So you can start to see why the oil price is being so resilient.

We’ve been suggesting you own or hold oil stocks since the coronavirus crash back in March last year and I still think it’s a valid argument. Companies are only going to keep coming under pressure not to dig or drill more. And in turn, that just means supply won’t be getting any bigger.

If companies spend less, and the stockpiles of the product they sell increase in value, then that means they’ll be more profitable. So even if it’s only a matter of time before the industry is a relic (and that in itself is a very contentious statement), then there’s still plenty of money to be generated.

So I’d hang onto your energy bets. We’ve covered this regularly in MoneyWeek magazine, and will almost certainly do so again in the near future, so if you don’t already subscribe, then get your first six issues free here.

And if you haven’t heard our latest podcast, have a listen to it now. Merryn has a suggestion on one market that should benefit in particular from the ongoing oil price strength. It’s not one you’ll all be happy about investing in – but it’s worth hearing the case nonetheless.

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