| | | I've been thinking about oil and there are a several factors that the common investors are not considering:
Let's make the bullish case first: Oil inventories are low and falling. There has been structural low investments by the oil industry and they are reluctant to make new investments. There are sanctions against Russia which is a major oil producer.
Am I missing anything?
Now let's make the bearish case for oil - but before I do that, I want to point out two things: (1) I am not calling a top on oil yet. (2) Oil prices don't have to go down for it to be a bad investment. With that in mind, let me have a go at it.
Firstly, everything I said about the bullish oil case has been well known and everyone and their grandmother is buying the oil stocks. Even Cramer is advising people to buy oil on dips. This means a lot, if not all of, the rosy picture is already priced in. When that happens, even if oil doesn't drop, it won't present a good risk/reward scenario.
Secondly, as I had predicted before the Russian oil sanctions, China and India are busy gorging on cheap Russian oil. As time goes on, the infrastructure for this get better entrenched. Furthermore, any economic pressure on Russia will force them to produce more oil and flood the markets with cheap oil. Should that coincide with any of the risk factors, such as removal sanctions on Iranian oil or a global economic slump, oil prices will crash.
In fact, my analysis based on the shape of the futures curve and implied volatility of oil options indicates that the market is pricing in a $150 oil within 9 months. So for purchase of oil at the moment to present a good risk/reward, you have to believe that WTIC will go above $150.
The case for buying oil stocks is different. A ton of oil companies went bust in the decade leading to 2021. Those who have survived are in a better market position. Shale oil will make more money this year than the entire twenty years of 2001 - 2020. Investors should pause and reflect on this. The bullish case for the oil stocks is that should the present conditions continue, oil stocks are arguably a great bargain. The bearish case is that you are buying a paradigm shift that says the last 20 years don't matter and it is now different - there won't be a reversion to the mean. Any of the risk factors above or a recession can turn the oil company fortunes around. This is why they don't want to invest in new oil production.
As I have said before, if I were to invest in oil, it would be in midstream companies. Investing in downstream companies can be done on a case by case basis provided you are confident of your assessment of the oil prices.
I don't have an opinion on upstream oil, but there is a nuance that many people are unfamiliar with. The US refineries are geared for heavy oil (i.e the kind you get from Russia) while the US produces light oil. This is why the US is both a major importer and a major exporter of oil. The US exports light oil and imports heavy oil. On the face of it, US upstream companies should experience margin compression as their access to cheap Russian oil has been cut off. But I see their stocks going up, so maybe I am wrong. Or maybe someone is pricing in a lower differential between Brent and WTIC. I don't know. I have not studied this.
The bottom line is that unless you know something that others don't, you should assume the prices represent fair value. If you are just trend following without a good cause, you won't be able to anticipate when the prices will rocket off or nosedive. Trend following is like kite surfing. You have to be in tune with the changing conditions above and below you. It is not as simple as buy the dip every time the MACD or stochastic tells you so. If it was, we'd all be billionaires. |
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