Should you invest in oil now?

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We’ve been answering our community’s money questions each week here on Medium. If you have a question which we haven’t addressed yet, you can submit it here.

Question: Should I invest in oil right now?

From our Investment Manager, Deirdre Rooney: Oil is hitting the headlines and new decade lows. The current low price of oil reflects that there is too much oil above ground (supply) and very low economic activity following the global coronavirus lockdown (demand). Crude oil lubricates the world’s economy and because of this, oil is a politicised commodity and is often used as a bargaining chip. Its production is controlled by a 24 national cartel called OPEC-plus so oil doesn’t trade in a free market like other commodities e.g. wheat or copper where there are no political constraints on production. Lastly, it takes time to turn the oil production taps on and off which means the price of oil is very sensitive to small shifts in supply and demand because any market imbalance takes time to correct.

The all-time high for the oil price was $120 approximately in 2008 and we’re back to price levels last seen 17 years ago. It’s a fair assumption that we are nearer a price bottom than a top. If you are looking to invest over a longer time horizon, then taking advantage of historically low prices may be a good idea and there are several ways to do that. The list below highlights the main routes to an oil investment for a retail investor and the risks of doing so:

1. Buy shares in oil companies that you think will do well over time. You’ll have the challenge of identifying which oil companies will be eventual winners out of the current chaos. It’s a difficult task without a crystal ball or detailed knowledge. Not everyone will survive a prolonged period of low oil prices. Diamond Offshore Drilling, a US oil services company and Whiting Petroleum have recently filed for bankruptcy. Many more will follow. You could buy a group of oil companies to diversify the impact of one company failing on the whole portfolio. But if corporate failures in the oil industry are more widespread, then the benefit of such diversification is lost as is your investment capital.

2. Buying oil through an ETF could be an interesting alternative, but you need to understand how the futures market works because oil ETFs don’t buy and sell oil itself. They synthetically create investments in oil through derivative markets such as oil futures. Investors who rushed into buying such ETFs are now seeing losses even though the price of oil has recovered marginally. This is because oil futures, which the ETFs buy and sell, are in contango i.e. the prices for future deliveries of oil are less than the spot price for immediate delivery. At one point recently, buyers were being paid by sellers to take contracts for oil delivery!

In a normal market, where demand and supply are balanced, prices for future delivery of a commodity are higher than the current spot price due to costs e.g. storing and transporting the commodity for delivery. This is known as backwardation. USO, the world’s largest oil fund, is taking losses as it scrambles to switch to longer-dated, higher priced oil futures contracts and has paid a stiff penalty to do so.

3. Buy shares in a crude oil tanker company. There is a glut of cheap oil in the world arising from the sudden collapse in demand due to the global coronavirus lockdown. Global land-based storage for crude oil supplies is at or near capacity such that buyers are seeking other ways to store their oil and have turned to crude oil tankers to create floating storage. Demand for these tankers is so high that rates have risen sharply to $250,000 per day for Very Large Crude Carriers (VLCCs) which are capable of storing 2 million barrels of oil. The CEO of Frontline recently called the current situation a “once in a lifetime opportunity” for the crude oil tanker industry. According to Euronav, a crude oil tanker company, it takes approximately 2 years to build a VLCC from the date of order which therefore limits tanker supply amidst rising demand and supports higher tanker rates. However, this stored oil can be easily moved and if there’s a spike in demand for oil as the world emerges from lockdown, it may get consumed first and demand for tankers fall.

4. Invest in a diversified portfolio. Our view on low oil prices is different: The benefits of a lower oil price to the world economy would be a huge stimulus for growth by lowering the cost of production across many industries — in particular airlines, transportation and chemical companies.

It will also offset inflationary pressures coming from the unprecedented levels of Government and Central Bank economic stimulus to prevent a deep, lasting economic recession following the global COVID lockdown. Higher oil prices mean higher production costs and therefore the price of goods and services rise i.e. cost-push inflation. Low interest rates encourage companies to borrow cheaply and develop their business. Loans increase the amount of money in an economy and also causes inflation.

This means that many companies, whole sectors and industries outside the oil industry will be better off because their costs are lower. In turn, this translates into higher profits and higher share prices. Not every oil-consuming industry will benefit to the same degree from low oil prices and some are facing challenges of survivorship during the global COVID lockdown so taking a diversified approach and investing broadly helps to reduce company and industry specific risk.

In conclusion, crude oil markets and producers face a difficult time ahead not only because of the current collapse in oil consumption and corresponding fall in prices but the future presents challenges too: We’ll need less oil as more electric vehicles take to the roads, cleaner greener fuels and energy are more widely used, climate and pollution policies are implemented globally and demand for single-use plastics is changed forever.

The oil industry will likely undergo yet another painful, costly restructuring to adapt to lower oil prices which will reduce earnings, impact dividends and therefore investment returns. It might be prudent to wait until the current battle is over before searching for survivors. Meanwhile, the benefits of lower oil prices will be seen by most other industries and create better investment opportunities.

Keep an eye out — more questions and answers to come! In the meantime, submit your question here and we’ll make sure to respond.

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