Is it time to buy oil?

Updated
Is it time to buy oil?
Is it time to buy oil?


Today we consider the astonishing collapse in oil.

The price made headlines on Monday when it slipped below $35 a barrel."Oil at seven-year lows", and all the rest of it, was all over the chattersphere.

So I bought.

Should you do the same?

The fortunes to be made in short-selling

We'll start with the very long-term picture. And, for the sake of a change, today I'll look at Brent (the European benchmark) rather than West Texas Intermediate (WTIC).

Below are the last 20 years. I've added some price labels.

Is it time to buy oil?
Is it time to buy oil?



What an amazing bull market that was. From under $10 a barrel in 1999, all the way to $146 in 2008.

And then what an amazing collapse. Four years of gains – 2004-08 – given back in six months. From $146 to $36.

Something similar happened last year. Several years of bull market given back in about six months.

Observation number one: when short sellers get it right, they make a lot of money very quickly.

I decided to buy oil – but it's a heck of a risky trade

My decision to buy (using a spreadbet – usual caveats apply, using leverage to bet on any price is highly risky, and your potential losses are far greater than your initial stake) was pretty knee-jerk.

There was just so much chatter about the oil price that an alert went off in my head. Noise like this normally marks some kind of market extremity. So I took on a small position.

The pedant in me would probably have waited. Closer inspection of the charts shows that we are actually still a dollar or two off the 2008 crash lows. But the decision has now been taken.

If we get a rally, I'll put a stop in above my entry point to de-risk the trade, but for now I don't actually have a stop. The obvious place to put one is just below the 2008 lows, but this thing is so volatile that I've decided to go for the small position option instead.

The reality is – I don't know where this one is going. The way this market has been, $20 doesn't look impossible.

On the basis of price history alone, there is a great deal of support in the $34-$36 area. Below $40 oil is "cheap" – at least judging by the metric that is my opinion. Given the devaluation of money that has occurred since 1999, and the growth in the money supply, oil at $35 is probably almost as cheap as it was at $10 in 1999.

Even with all the improvements in technology and productivity that have been made, it seems that most of the oil-producing companies and countries cannot make money with oil below $40. You'd think that would mean less supply. In fact, the opposite happens.

Lower margins mean production gets ramped up. If before you were making $10 a barrel, but now you are only making $5, double your production and you still make the same overall profit.

That is a grossly simplified version of what is going on. But it is one explanation for this glut of supply that keeps pushing prices down.

Given the sizeable costs involved in shutting down an operation, it is often better to keep it running, even if it is loss-making. Borrow the money instead. Ramp up production. Improve efficiency. Cut costs. Shutting down operations means CEOs risk losing their jobs. They've got fat-cat salaries to protect.

As long as this situation remains, there is going to be downward pressure on prices.

And it is setting the stage for a monster bull market somewhere down the road. At some point a number of things will conspire.

The coming bull market in oil

Debt will become more expensive, reducing options to fund operations in this way. The margin clerks will get on the phone. Unprofitable operations will not be able to continue and will have to shut down.

There will be less and less cheap-to-produce oil, as most of it will have been extracted. We will be reminded that nothing has been spent on exploration, resulting in low levels of discovery.

The subsequent strain on supply will push up prices. Narratives such as 'Peak Oil' – remember that? I was a subscriber. It looks silly now, though it's probably still true – will make their way back into the conscious. And we will all wonder how on earth we can have been so stupid: one, to have been so wasteful when it was plentiful; and, two, not to have bought thousands of barrels of the stuff while we could.

Such is the crazy cycle in commodities.

I think we might be a way from any bull market yet. But, all the same, what's coming is pretty foreseeable. We're probably at the first stage of the turnaround – when debt is getting more expensive and not so freely available. That seems to be the message of the junk bond market.

I'm catching a falling knife with my trade, I accept that. But it's only a small knife. And I've got gloves on.

When I've caught this knife before, both times I've enjoyed a bit of a rally, moved stops up and then got stopped out as the market turns back down.

For now the trend is down – and you know what I say about trends. But we're at a juncture where trends have ended before.

So, to answer my initial question, should you buy? I would say only if you do so with your eyes wide open. Buying during a collapse is a dangerous pastime. And this is a commodities collapse. One heck of one.

(By the way, my colleague Alex Williams is writing about the collapse in the mining sector this week – and the opportunities arising from it – so make sure you read MoneyWeek magazine this week. If you're not already subscriber, sign up here.)

Why Low Oil Prices
Why Low Oil Prices

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