Friday, November 28, 2014

The Oil Trade

"The formula for success: rise early, work hard, strike oil."

-J. Paul Getty

Welcome to The Golden Sense! Dutch painter Vincent Van Gogh lived from 1853 to 1890. What is less known about him is that he painted only for the final 10 years of his life until mental illness overcame him and he committed suicide. During that time he created a massive output, creating some 1,100 drawings and 900 oil paintings, plus numerous sketches and other works. Today he is one of the most admired and well-known painters of any era, although he did not sell even one painting during his lifetime.

Success comes in many different ways, whether it's expressing a deteriorating yet brilliant mind like Vincent Van Gogh or shrewdly building an oil empire like J. Paul Getty; success appears to be a product of timing.

Timing an event, trend, or pattern is very difficult. Nobody knows what the future holds but sometimes people take a chance on intuition and strike it rich.

In the latter part of 2014 some interesting developments have taken place in regard to the price of oil.

The price of oil has fallen below $70 a barrel for the first time since 2010. The chart below shows that the price of oil in the past four years has fluctuated between $90-$100 a barrel with the higher prices typically occurring in the spring to summer time period.

The falling oil price is a supply-demand problem. Demand is slowing with slow global growth while the supply is abundant. The Organization of the Petroleum Exporting Countries (OPEC) is a group of 12 nation including Saudi Arabia, Iran and Venezuela that holds enormous power over global energy market. They have been keeping oil production high despite the slowing demand.

The United States has seen a major growth in oil production, thanks to the shale oil revolution, in which new technologies like horizontal drilling have allowed access to hydrocarbons deep beneath the Earth's surface.

By suppressing the oil price, OPEC squeezes the profit margins of the costlier shale oil producers (fracking) in the United States. U.S. shale production is now a serious contender in the oil game and the world is taking notice.

The fall in oil has hurt the producing countries like Russia, Norway, Canada, Mexico and Brazil. These countries, like the U.S. shale oil producers, are seeing their profits squeezed by the lower price.

Most oil producers would prefer to have the price in the $90-$100 range. This price creates a much better profit margin. This price range is in everyone’s common interest. Some countries can produce at cheaper levels than others, but in grand scheme of things, a lower price is not a long term benefit.

It looks like this oversupply (lower oil price) could last awhile...but not forever. This is where opportunity arrives. The recent sell off in oil has created the perfect buy window. I don't know when, but there is a good chance we will see $90 barrel oil again.

There are many ways to play this trade. Sophisticated investors might find smaller oil companies with reduced share prices to purchase. This is a very legitimate play, but it takes research from someone that knows what they are doing.

Professionals often take positions out in the futures market to trade on the future price of oil. To do this you need to have a futures trading account. To have this kind of account you often need to show an investment bank that you have a boat load of money to cover your margins. These trades aren't practical for the little guy investor.

The best way to make this play is buy shares in oil ETF's (exchange traded funds). You can do this using any brokerage account. The following ETF's are worth a look.

  • DBO- PowerShares DB Oil Fund
  • USO- United States Oil Fund

Both of these ETF's invest in West Texas Intermediate future contracts. If the price of oil goes up or down you can expect the price of these ETF's to do the same thing. Purchasing one of these ETF's is as easy as buying any stock. This makes the oil trade straight forward and simple.

Of course, nothing is a sure thing and there are plenty of people claiming that lower oil prices are a thing of the future. I'm not so sure. Market forces are stronger than any group of producers, particularly in finite industries like oil production. I see the price of oil going back up over the long run.

Taking a chance isn't easy. However, this one might be worth looking into.

Over and Out,

T. Norman