How to cash in on the oil price collapse

Where there is crisis, there's often opportunity -- and crude oil's tumbling fortunes are a case in point.

Marketwatch

The collapse of crude oil over the last year is one of the biggest asset crashes since the Great Recession and where there’s crisis, there’s often opportunity.

From a historical perspective, this collapse ranks a bit smaller than the crash in 2008. During that period, crude dropped from $US140 per barrel to $US40. While the current drop from $US108 per barrel during the June 2014 peak to $US46 is significantly smaller, that they’re comparable at all is staggering.

One of the biggest lessons from the financial-market crash half a decade ago was ignoring panic and instead scooping up good assets at fire-sale prices. Would that lesson apply to oil today?

The first thing to consider is whether there’s any reason prices will recover at all. What are the fundamentals?

Unlike corporations, oil as a commodity can’t really go bankrupt. Oil is a necessity, demand is relatively inelastic, and it dominates in practically everything that requires energy. It’ll always be needed over the immediate timeframe. While the price may not hit $US100 again in the short term, there is a fundamental limit to how low it can go.

At a bare minimum, oil should always cost what it takes to pump it out. According to 2008 estimates from the International Energy Agency, that value varies considerably depending on location and efficiency. Middle Eastern oil has been estimated to cost approximately $US6-$US10 per barrel due to the large economy of scale and the relatively mild near-surface conditions. Though these locations have very low costs, they don’t have sufficient capacity by themselves to satiate demand. For other onshore pumping, costs can be around $US6-$US39, and for deep-water offshore wells, costs can reach $US32-$US65 or more.

More difficult sources such as oil sands were estimated at around $US30-$US70 and shale oil wells were estimated at $US50-$US100. Since the cause of oil’s current crash is rooted in Saudi Arabia’s goal to push shale oil out of business while leaving conventional drilling profitable, there’s a potential bottom of $US30-50 per barrel -- close to today’s prices. While nobody except Saudi Arabia knows for sure, there’s a high chance prices will be allowed to rise once the goal of squeezing shale is complete.

Second consideration: How long would it take to profit from such an investment?

History doesn’t have a clear answer on this as the 1980s oil crash took decades to recover. However the 2009 oil crash only took 2 years, much faster than the stockmarket recovery. If Saudi Arabia’s goal is to push shale out, taking into account how long hedges last for, how long companies can operate in the red, and how fast they can slim down, one to three years may be reasonable.

Lastly, the most important question: How to profit from this? For the average retail investor, this is trickier than at first glance. The most obvious ways are betting on the crude-oil commodity price itself, betting on energy-sector companies and betting on oil-producing countries.

Three options to profit

Betting on crude oil prices as a commodity may seem the simplest -- it avoids questions of business fundamentals, it can’t go bankrupt and, as mentioned above, likely has a price floor. But commodity bets are typically done via the futures market. Unless you own a few supertankers, there’s no easy way to profit via hoarding or storing, the commodity equivalent of buy and hold.

For most retail investors that don’t play the futures market, there are several US-listed ETFs available such as the United States Oil Fund, the 2x leveraged equivalent Proshares Ultra Crude Oil, and the Powershares DB Oil ETF. These funds all have their pros and cons.

For example, USO is a limited partnership which can cause tax-filing headaches; UCO is leveraged on a daily price basis and thus falls into the common problem of long-term tracking error. As expected, they also tend to have high fees, ranging from 0.6 per cent to 1 per cent.

However, the biggest fundamental problem with these ETFs is how they track oil prices via leveraged futures derivatives. Futures can be analogous to stock options, for example -- they both have expiration dates. As futures expire and are rolled over, these ETFs suffer tracking error due to changes in the roll yield.

Backwardation and contango can thus impact returns, especially in volatile markets. After 2008 when oil prices dropped and recovered, USO stayed flat for years while crude prices rose thanks to the contango effect. As a result, by 2014 crude-oil prices had recovered near their 2008 peak while USO was still down 66 per cent -- not pretty. If you choose to play these funds long term, caution should be used.

Betting on energy-sector companies is another approach. Because companies react dynamically, this can be positive or negative. Small oil companies that overleveraged will be crushed while larger, well-capitalised companies can reduce investments and emerge stronger with less competition. In this situation, invest in the largest and strongest oil companies such as Exxon Mobli or in the energy industry as a whole.

The largest energy-industry ETF is the Energy Select SPDR Fund (XLE), followed distantly by Vanguard Energy Index (VDE). Both invest largely in integrated oil and gas firms, exploration and production, equipment and services, and others.

Additionally, there are ETFs focused on specific industry niches such as the Market Vectors Oil Services ETF (OIH) and iShares US Oil Equipment and Services. These hold companies such as Schlumberger and Halliburton, representing another avenue of exposure. The danger here is that many of these companies may be the most susceptible to slowdowns and, like the industry as a whole, their stock may have yet to fully discount future poor earnings.

Instead of individual companies, some may consider the largest oil bets: the country producers. For many, oil is essentially their lifeblood and they live or die on crude prices. Middle Eastern countries such as Saudi Arabia, Iran, Iraq, Kuwait, UAE, and others such as Venezuela, Nigeria and Russia are all essentially oil plays.

However, these are suboptimal bets in many ways. Saudi Arabian and Iranian financial markets aren’t exactly open and available, Russia suffers from a currency crisis and sanctions, Venezuela is just plan collapsing. The list goes on. Though interesting to consider, there are just too many uncertainties.

As oil prices have started to show signs of stabilization recently, it may be time to consider the benefits as well as risks to jumping in. It may not pay off in the next week or month but fire-sale discounts for essential products like oil may represent opportunities for the next year or more.

Disclaimer: the author currently has a long position on XLE.

This article was first published on Marketwatch. Reproduced with permission. 

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