What you need to consider before investing in oil and other commodities. Two schools of thought regarding the direction of oil prices.
In this episode, you’ll learn:
- Why oil prices are being driven by a herd mentality.
- What led to the oil renaissance in the U.S.
- The school of thought for why the drop in oil prices is temporary.
- What is the commodities super-cycle and why commodities move in long-term cycles.
- What is the spot price.
- What drives the returns of commodities futures.
- What is the roll yield, contango and backwardation.
To learn more about investing in commodity ETFs, check out this guide.
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Are Low Oil Prices Here To Stay?
The stunning 50% decline in oil prices over a six month period is an excellent example of why investing is so difficult.
The oil price drop was unexpected, it has been far more severe than anyone anticipated and now with oil prices at under $50 a barrel the question is what’s next.
Have oil prices bottomed or will they continue to fall?
Howard Marks, Chairman of Oaktree Capital Management and author of the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor writes, “Investing requires us to position a portfolio for future developments, but the future isn’t knowable.”
This puts professional investors in a bit of a pickle as their average client believes that the future is indeed knowable and they pay the advisor hefty fees to successfully discern the future and profit from it.
One way professional investors deal with these unrealistic expectations is by mimicking what their competitors do.
Jeremy Grantham, Chief Investment Strategist and co-founder of the investment firm GMO writes,
“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money.
The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own.
To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing.
The great majority ‘go with the flow,’ either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price.”
Certainly crowd psychology and herding has magnified the drop in oil prices.
As individual investors we are not exposed to career risk. Consequently, we do not have to follow the crowd when making investment decisions.
Jeremy Grantham also wrote, “The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals.”
Is oil at its current price a fat pitch for investors?
I don’t know. I’m torn between two schools of thought.
The Oil Price Decline Is Temporary
The first is the oil price decline is due to a temporary mismatch between supply and demand.
The excess supply originates from America’s heartland where over the past eight years there has been a major expansion in oil production using fracking and horizontal drilling techniques.
With the drop in oil prices, operators already appear to be cutting back production as the break-even cost for many of these wells is above the current price of oil.
Outside North America, oil production has been flat for a number of years so with the marginal supply coming from North America the oil price decline should lead to a slowdown if not a reduction in supply.
Meanwhile, global demand for oil has also slackened as global economic growth has moderated.
This school of thought suggests the demand/supply imbalance is temporary and the oil price has overshot to the downside led by speculators and professional investors worried about career risk.
It is quite possible the cutback in supply will also overshoot as operators remain gun-shy to restart existing wells or initiate new projects fearing a price recovery is only temporary.
At that point, if global economic growth continues then oil demand will outpace supply resulting in a return to $80 to $100 oil prices.
Oil Prices Will Stay Depressed For Years
The other school of thought is historical. Commodity prices tend to move in long-term cycles with bull markets (uptrends) and bear markets (downtrends) lasting 15 to 20 years each.
The reason for this is it takes years for extraction industries like oil and mining to ramp up production in order to meet increased demand.
The current commodities super-cycle that began in 1999 was fueled by China’s voracious appetite for oil and other commodities as it rapidly industrialized.
Now with China’s economic growth slowing as it attempts to shift to a more consumer-led economy from one driven by infrastructure investment there is a risk that the current commodities super-cycle is dying.
Last year, China imported record amounts of commodities including oil, yet commodity prices still fell suggesting an excess of global commodities producing capacity. If demand for commodities moderates, we could be in for a decade or more of stagnant to falling commodity prices. As it stands, commodity prices are already down significantly from their 2011 peak.
The good news in this scenario is inflation will remain at bay. In addition, stocks and commodities tend to move counter cyclically so commodities bear markets tend to be accompanied by equity bull markets.
Bottom line when it comes to oil investing I intend to use my prerogative as an individual investor to remain in the dugout and see how the game progresses.