Another week, another impressive fall in oil prices.
There have been a series of psychological thresholds through which oil prices have crashed over the past few months. In the beginning of October, oil prices dropped below $90, only to slip past $80 by the end of the month. Prices then dropped more slowly through November, until the OPEC announced its decision to leave its production quota unchanged. From there, all bets were off – oil prices crashed through $70 and then $60 per barrel within two weeks.
In the first week of January, price projections were once again thrown out the window with WTI dipping below another crucial threshold – $50 per barrel. At each level, investors who went long on the energy industry – thinking that prices had bottomed out – were demolished.
At this point, it may sound reckless to try and predict which way oil prices are going, but here goes: oil prices are nearing a bottom and there is an enormous opportunity to ride the wave back up.
But before we get there, let’s take stock of the industry.
Financial Bloodshed Across the Sector
Watching oil prices drop by more than 50% in six months is something that only comes around once every decade or two, so investors should appreciate the magnitude of what is going on here. There have always been booms and busts in the oil industry but we are currently witnessing a profound bust not seen since the 1980’s (prices crashed further…
Another week, another impressive fall in oil prices.
There have been a series of psychological thresholds through which oil prices have crashed over the past few months. In the beginning of October, oil prices dropped below $90, only to slip past $80 by the end of the month. Prices then dropped more slowly through November, until the OPEC announced its decision to leave its production quota unchanged. From there, all bets were off – oil prices crashed through $70 and then $60 per barrel within two weeks.
In the first week of January, price projections were once again thrown out the window with WTI dipping below another crucial threshold – $50 per barrel. At each level, investors who went long on the energy industry – thinking that prices had bottomed out – were demolished.
At this point, it may sound reckless to try and predict which way oil prices are going, but here goes: oil prices are nearing a bottom and there is an enormous opportunity to ride the wave back up.
But before we get there, let’s take stock of the industry.
Financial Bloodshed Across the Sector
Watching oil prices drop by more than 50% in six months is something that only comes around once every decade or two, so investors should appreciate the magnitude of what is going on here. There have always been booms and busts in the oil industry but we are currently witnessing a profound bust not seen since the 1980’s (prices crashed further in 2008-2009, but the blame for that can be pinned on the financial crisis. The current crash is an authentic oil bust, with supply far outstripping demand).
That means very few companies will emerge unscathed. First and foremost, small and medium sized upstream companies are fighting for their lives by dramatically scaling back spending. Only a heroic retrenching will allow many to survive. Even then, some companies could face a liquidity trap if oil prices don’t rebound – banks and financial institutions will pull their money from the weakest in the herd, at which point companies could go belly up.
Already several companies are nearing disaster. Let’s take one example. Goodrich Petroleum (NYSE: GDP) has seen its share price tank, losing 90 percent of its value since June 2014. The debt-ridden company has bet on the high-cost Tuscaloosa Shale, a lesser-developed shale region in Louisiana and Mississippi. Clouds are forming over the company – it is required to generate EBITDA of at least $150 million for the year (one quarter of its $600 million in accrued debt), but that is looking fanciful. The company’s stock cratered by another 11% on January 7 after it was downgraded to “hold” by investment firm Raymond James.
A similar story is playing out for a series of companies just like Goodrich. Energy XXI (NASDAQ: XXI), Quicksilver (NYSE: KWK), Halcon Resources (NYSE: HK), and Sanchez Energy (NYSE: SN) are just a few of the names that are shedding costs to stay solvent.
In fact, Deutsche Bank said in December that nearly one-third of the oil companies with a rating of B or CCC would face a default scenario if oil prices dropped below $55.
Larger, integrated oil companies are much more insulated from the oil price collapse as their refining divisions can mop up extra earnings with lower input costs. Still, even they are facing longer-term problems. Citi Research finds that spending levels for the 12 biggest private oil companies were 24% higher than their cash flows in 2013, a year in which oil prices were much higher than they are now. With more cash going out than coming in, the oil majors will either have to further slash capital expenditures or even do the unthinkable – slash dividend payments to shareholders. To be sure, they will ride out the rough times and come out alright, but they don’t exactly offer a huge upside right now.
Hitch Your Wagon To Oil
Nevertheless, a turnaround is at hand. The market has oversold oil. While there is indeed too much supply, the markets are acting out of fear that there will be no bottom. But prices are unsustainably low and the pace of drilling is unsustainably high, so while oil may drop a bit further in the short-run, over the course of the year it will have to head back up. Now is the time to jump in.
Supply is still surpassing demand, but demand is picking up. Despite real gains in fuel economy, U.S. drivers are burning through gasoline at one of the highest rates on record. And it is just a matter of time before the rest of the world begins picking up the slack, as a fundamental tenet of economics is that low prices will spur more demand. That makes an oil price rebound a certainty and a good opportunity for savvy investors.
But be wary of individual companies. As we mentioned, there is a lot of debt beginning to accumulate, with smaller companies potentially being pushed out of the market. Finding the gems amid all the rough could be difficult. Better to bet on the sector as a whole rather than trying to pluck out specific winners amid all the carnage.
That means betting big on the sector as a whole. After all, oil cannot go bankrupt. That means putting money into exchange-traded funds that bet on oil prices themselves.
Many investors are starting to see the opportunity. In December, investors injected $1.23 billion into oil exchange-traded funds (ETFs), the most in four years.
There are several major oil-based ETFs to consider, the largest of which is the U.S. Oil Fund (NYSEARCA: USO).The ETF tracks the price of WTI, and has seen its value fall by half since July (following WTI’s descent). With investors already starting to get in on the fund, the only way to go is up. Trading between $18 and $19, the fund is offering a mouth-watering entry point. Short sales are way down too, pointing to a growing consensus that WTI is bottoming out. WTI could drop down to the mid or even low-$40 per barrel range, but the notion that it will bounce back well above $50 is a near certainty.
Another fund with a similar structure and trade exposure is the iPath S&P GSCI Crude Oil Total Return (NYSEARCA: OIL), which bets on WTI as well.
Another way of playing oil prices is by betting on volatility. The CBOE Crude Volatility Index (INDEXCBOE: OVX) bets on options from the USO, and it rockets upwards when crude prices are volatile. In other words, it isn’t necessarily the price that matters, but merely the volume of trading. CBOE has seen its value nearly quadruple since the summer – with oil prices bouncing around, there is more money to be made. With that said, there is less of an entry point now that the fund is at its highest level in years, but it offers a good hedge against price stability for any investor’s portfolio.
Yet another way of playing oil prices is by betting on the products that use oil. Think cars, trucks, planes, rail, and other freight. With oil prices down, one of the huge input costs for these sectors just got slashed in half. Auto sales are the best they have been in almost a decade, and airlines are cashing in on cheap oil. To get exposure to this, check out the iShares Dow Jones Transport Average (NYSEARCA: IYT), an index that tracks the performance of the transport sector as a whole.
Conclusion
The oil sector is witnessing a historic moment with the price crash. But prices are now at unjustifiable and untenable levels. While the timing and magnitude are unclear, a price rise is inevitable.
And right now the sector is offering investors a massive entry point. To reiterate, individual companies could be risky bets with debt piling up, but oil as a whole is not. Oil ETFs offer the best and surest way to make money this year.
