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Strike While The Majors Are Cheap

This big collapse in the price of oil that has occurred in the second half of this year is the result of a combination of factors. Dollar strength as other major economies, such as Japan and Europe, face problems has played a part, as has some worry about a slowing of global growth. If the numbers are to be believed, though, the single biggest factor has been the increase in supply as unconventional wells, most notably in the U.S., have come on stream. Understanding that this is principally a supply shock is important for investors as it determines strategy for next year.

The evidence is easy to find. The most recent Short Term Energy Outlook report from the U.S. Energy Information Agency estimates that the global supply of crude has increased from 90.16 million BBL/D in 2013 to 91.96 million this year, an increase of 1.8 million BBL/D, while total global consumption has increased from 90.48 million BBL/D to 91.44. Not only does this tell us that supply is increasing faster than demand, it also shows that the world as a whole has gone from a production shortfall to a surplus. It should also be noted, though, that although lagging behind the rate of supply increase, demand is still in an upward trend.

The point is though, that absent any unforeseen influence, supply distortions correct quite rapidly. The price fall stimulates demand, while supply growth is rapidly slowed as more expensive production is halted. The “invisible hand” that guides markets comes into play quite quickly. Compare that to a situation where demand is the problem, such as we saw in 2008 and the difference is glaring. When the world is in recession, recovery takes time and even as prices drop, demand continues to fall.

So, unless you really believe that we are heading for a repeat of 2008 in terms of a huge global recession, the obvious conclusion is that this supply induced fall in oil prices will correct itself in the first half of next year. It makes sense for investors to position themselves for that.

Even though the selling looks overdone without demand problems, momentum is a powerful thing, so a conservative approach is called for. Even if prices stabilize here and begin to trend upwards there will be several small, highly leveraged U.S. producers facing enormous difficulty, so taking on risk in those areas would be brave to the point of foolishness. Large, multinational producers, however, with cash reserves to ride out a fairly short storm look attractive at these levels.

In the last few days, those stocks have begun to bounce, but Chevron (CVX), for example is still trading at around a 20 percent discount to highs earlier in the year.

Chevron Chart 1

In this case, the fact that a bottom has already formed at around $100 gives investors an opportunity to buy at current levels, around $107, with a stop loss around 8 percent away limiting potential losses.

Chevron Chart 2

If, as expected, there is no major shock on the demand side and supply issues prove to be self-correcting, then Chevron will continue about its business of making money and the upward trend indicated by the 10 year chart will resume.

The evidence we have certainly suggests that over-supply is the problem oil has faced in the last few months. There may be some uncertainty about the pace of growth in global demand, but very few people believe that it will actually fall. Given that, taking the opportunity to buy the big boys of oil such as CVX makes sense.

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