If you're the type to buy straw hats in winter, you've probably been wondering about the potential profits of investing in oil. Here's how to do it -- and how not to.
It wasn’t long ago that pulling up to the pump was as much fun as a trip to the dentist, and just about as expensive.
How times have changed.
While you’re probably not laughing out loud as you fill the family ride these days, your bank account is certainly smiling.
Oil has always been a wild ride, offering frightening spikes and spectacular falls. But this cycle is one for the record books. At recent lows, oil prices have plunged 70 percent in less than two years, saving the average American household more than $500 in 2015.
So, let me ask you two questions:
- Think low prices will last forever?
- Wanna bet?
If you answered “no” to the first question and “yes” to the second, it’s time to learn about how best to make money in the oil patch. I’ll include a brief explanation of why oil is cheap, why it may not stay that way, and how you might be able to profit.
Why oil prices are so low
You don’t have to drill down very far to answer this one. Oil prices are low because there’s more supply than there is demand.
The United States is now pumping nearly twice the oil it was in 2010, thanks largely to new technology. That, along with increasing output from traditional producers, like Saudi Arabia, Russia, Iraq and, most recently, Iran, have the world awash in oil.
On the demand side, the world’s economies aren’t firing on all cylinders. China’s economy is still growing, but at a lower rate than it was just a few years ago. Europe is basically treading water, and growth here at home is tepid at best.
It’s a perfect storm. Every day, big oil is pumping 2 million barrels more than the sluggish economies of world require. If you remember Econ 101, you know that when supply outstrips demand, you’ve got a recipe for falling prices.
How we got here
Even if you didn’t take Econ 101, rest assured that oil producers are well aware of what happens when they produce more oil than the market needs. So why haven’t the largest producers cut back production to stabilize prices?
First, when your entire economy relies on oil, you need to keep producing it. Venezuela gets 95 percent of its export earnings from energy, and Russia nearly 70 percent. Many oil-producing countries depend on oil revenue to feed their citizens and keep their governments in power.
If you sell widgets to feed your family and the price of widgets plummets, you don’t stop selling widgets. If you don’t want your family to go hungry, you sell more of them to make up the difference.
Reason two: Low oil prices are no accident. They were deliberately engineered in a high-stakes gamble by the world’s largest producer of oil, Saudi Arabia. Saudi Arabia, along with other OPEC members, are seeking to destroy competition from the United States and other producers, thus keeping their stranglehold on the market.
By some estimates, the cost to recover a barrel of oil in the United States is about $36. In Saudi Arabia, it’s closer to $10. So at today’s $30 per barrel prices, the Saudis are still profitable, but we aren’t. It’s a strategy as old as commerce: Undercut your competition, and drive them out of business.
Why oil prices won’t stay low forever
Both factors that are keeping oil cheap — low demand and oversupply — will eventually resolve themselves. But the key word is eventually.
There are signs that the world economy is heading toward recession. While that’s far from certain, should it occur, it obviously won’t help the demand side of the equation. But sooner or later, things will look brighter, global economies will once again expand, and the demand for oil will increase.
There are also beginning to be signs that the oversupply problem may fade sooner rather than later, because Saudi Arabia’s gamble is paying off. According to the New York Times:
Earnings are down for companies that made record profits in recent years, leading them to decommission more than two-thirds of their rigs and sharply cut investment in exploration and production. Scores of companies have gone bankrupt and an estimated 250,000 oil workers have lost their jobs.
This is the outcome Saudi Arabia was hoping for. As the United States shuts down unprofitable wells, there’s less oil on the market. Less oil means higher prices. In addition, countries that depend on oil for their economic viability are increasingly clamoring for cooperation among producers to reduce output.
Even if the global economy begins to recover and producers curtail production, however, it’s unlikely that oil will soon spurt back to $100/barrel. As prices rise, the United States and other higher-cost producers will re-enter the fray and add more supply, keeping a cap on prices. Still, that cap is probably closer to $60 per barrel than today’s $30, so there’s plenty of potential oil upside.
Betting on oil: What not to do
The most dangerous way to invest in oil is to use commodity futures contracts. Commodity contracts represent a highly leveraged, short-term bet on prices. People involved in this arena gamble thousands on short-term price swings in oil. That’s far too risky for the average investor.