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.
What some small investors might be tempted to do, however, is to buy energy-related exchange traded funds, or ETFs. These are essentially mutual funds that trade like stocks on exchanges. One of the most popular in the energy sector is the US Oil Trust (USO). But this popular ETF isn’t as safe as it appears. While USO is an ETF, it invests in oil commodity futures contracts, rather than putting money into something far more stable, like the stocks of oil companies.
Even more risky are ETFs that not only mimic futures, they also borrow money to leverage the bet. One of the most popular, VelocityShares 3X Long Crude Oil ETN (UWTI), is down about 90 percent over the last year. No thanks.
Betting on oil the sane way
The least risky way to invest in the recovery of the energy sector is to use an ETF or mutual fund that owns oil company stocks, preferably a lot of them. The one I like best is Vanguard’s Energy ETF (VDE). This ETF owns the stocks of 144 oil companies, including the world’s largest. While you’re waiting for oil to recover, you’ll also earn a dividend, currently at 3.3 percent. You can buy it anywhere stocks are sold.
I have no affiliation with Vanguard, although I do have an account there. The reason I’m suggesting this ETF is because it’s among the lowest cost. The annual expenses are a skinny 0.1 percent. But if you want to shop around, I encourage you to do so.
Another option, of course, is to simply buy the stocks of individual oil companies. But since an ETF gives you much greater diversification and the costs are low, why bother?
Here’s what I did. Should you do it too?
On Feb. 10, I invested some of my 401(k) money in the Vanguard Energy Investors mutual fund (VGENX). Because it’s a 401(k), I’m not able to buy ETFs, which is why I couldn’t buy the ETF above and bought its mutual fund cousin instead. The expense ratio is significantly higher; 0.37 percent versus 0.1 percent, but that’s the extra price I have to pay for a mutual fund.
As I write this, I’m up about 5 percent. But that investment was just the first of many I’m planning. My strategy is to buy equal amounts monthly for the next six months. The oil recovery isn’t going to happen overnight. It may take years. The prudent approach, as with any investment strategy, is to dollar-cost average into a position. Putting in equal amounts at regular intervals means automatically buying more shares when prices are low and fewer when they’re higher.
Now that I’ve told you what to do, what not to do and how to do it, should you?
That depends. Investing in stocks entails risk, and investing in specific sectors, like oil, magnifies the risk immensely. Don’t ever invest in stocks with money that you’ll need within five years. Don’t ever invest in anything you don’t thoroughly understand. And don’t ever invest so much that you become freaked out. If you’re scared, you either invested too much or you don’t have enough understanding of what you’re doing.
And don’t ever think that just because I’m doing something, or anyone else is, you should.
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I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.
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