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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Crude Oil Price Slump is a Once in a Decade Opportunity to Make Money, Guaranteed

Commodities / Crude Oil Jul 23, 2015 - 12:51 PM GMT

By: Atlantic_Perspective

Commodities All investments carry risk. There are no safe investments in the sense that “you just can´t lose”. But risk can be greatly reduced, according to the entry point and the timespan of the investment.

The commodities cycle
The world is currently awashed in oil and natural gas. This is the reality of today. But as sure as day follows night, this glut will turn into production deficit over the next few years. All commodities traders know this and have seen gluts turn into deficits dozens of times, in different markets.  Why does this happen?


As the price of a given commodity rises, more and more players come into the market to produce it. This is true for agricultural products, metals, energy, etc. The growth in supply eventually puts an end to the price increase. Supply and demand reach an equilibrium. But this equilibrium may last only a fraction of time, sometimes measured in seconds. Why?

Producing oil and natural gas requires huge capital investments and a long list of permits. Between the decision to produce and the first actual oil/gas coming to surface, we are talking about months at best, but it usually takes years.

As the oil price goes up, more and more producers join the energy bandwagon. At some point, supply outpaces demand. But this doesn´t prevent more oil from coming to the market. When you invest millions/billions on something, you really need to get your money back. And the only way to achieve this goal is to keep producing. Last year, as oil prices crashed, oil producers kept producing. Actually, they had to produce even more to compensate for the price decline. And this is how we came to the current glut.

Inefficient oil producers will be put out of the market, once the oil price falls below the cost of production. Most producers can deal with negative returns for a few months, but definitely not for years. So, once the cash runs out, the operation closes. Now, multiply this by hundreds of operations. Then thousands. This process is usually quite fast. Within just a few months, millions of barrels of oil stop coming into the market. Eventually, the drop in price will lead to a production deficit and oil prices start to rise again. This means production starts to increase again, right?

No. Opening and closing oil operations costs millions and takes a lot of time. After a prolonged period of low oil prices, producers become weary of any price increase. An attitude of “let´s wait a bit more to see if this price rise really sticks” takes hold and prevents new investments from taking place. Thousands of operations remain on standby, waiting to see if the price rise really sticks.

Once it is clear that the price rise will stick, it will take months or even years to get new production into the market. In the meantime, oil prices explode.

Commodities and the stock market present different opportunities and risk. In the stock market, investors take the risk of losing money in case of corporate bankruptcy or a widespread crash. But in commodities, the big risk is a supply shock. Supply shocks lead to price explosions akin to a crash, but in the ascending way.

The case for oil

Nobody knows how low the oil price will go, or when the low will happen. Anyone claiming to know the oil price low or the specific timeframe of this occurrence, is either lying or delusional. Markets usually fool most participants by either moving too quickly or too slowly, or reaching unthinkable prices (high or low). All of this presents a huge financial risk. Is there a way to reduce the risk?

Yes. The answer lies in time. Investing in oil, directly through ETFs or indirectly via oil companies, will be more or less risky according to the investment timespan. Investing for the next 6 months - expecting that oil will become more expensive by the end of the year - is extremely risky. But if your investment horizon is 5 years, it is virtually impossible that over that time frame oil will not go up at some point. The commodities cycle always works.

Oil is not something we buy out of pleasure, it´s something we need. Over the next 5 years, supply will eventually crash as more and more producers are put out of business. And when the oil market reaches production deficit (which it eventually will), prices will sky rocket because no new production will come online for a meaningful period of time.

It is impossible to know or predict how low oil will go, and how much longer the slump will last. But we do know that the slump will not last forever and that it will end with a price bang to the upside. Five years seems like a very reasonable investing horizon to collect a high octane reward. This doesn´t mean that you should invest in oil for exactly 5 years, it means that you have to be prepared to wait at least five years before investing. The exact moment to leave the market will depend on the assessment of the situation as it unfolds.

The risk/reward ratio

At around $50 per barrel, oil presents an excellent buying opportunity. Some analysts say that it can go as low as $30. If that does happen, the supply deficit will be huge and prices are guaranteed to at least double from that low. If and when the oil price goes back to $60 (a very conservative estimate over a 5 year period), if you bought at $50 you will get a 20% gain in 5 years. That´s better than T-Bonds, and probably safer in today´s world...

What if oil goes back to $80? Once again, it´s not a crazy expectation, it has been much higher than that for years. In this case, you would get a 60% profit. The last time oil prices crashed (2009), oil more than tripled in value just 2 years after the low. The $80 oil forecast is therefore quite attainable and probably conservative.

The big bonus: if you decide to invest in oil via oil companies, there is a very good chance the shares will rise at a faster pace than the oil price increase (example: oil price goes up 30%, oil producers rise 50%). That is how shares of commodity producers usually behave (there is a mathematical reason for this that will not be explained in this article).

It is highly unlikely that oil will remain below $50 over the next 5 years. Only a worldwide wave of deflation would support such an anomaly, and in that case, most other investment options would present an even bigger risk of loss. The downside for oil from current levels is much smaller when compared with most other investment classes.

How to invest in the future oil price rise

1. You can either make your 5 year investment all at once, or divide it over a 6-12 month period by investing a fix amount every month, till you reach the whole investment allocated to oil. This will allow you to buy cheaper if the price of oil keeps going down, but you risk buying at a higher price if the low is reached in the meantime and prices start to rise again. This being a long term investment, we suggest that you buy over a 6-12 months period. If at some point the oil price goes above your “comfort price”, you just stop buying and enjoy the profits on what you already bought.

2. Diversify your investments. Buy oil ETFs and oil companies from different continents.

3. If you buy shares, choose well established companies that pay dividends. This is an investment in the overall oil market, not in company A, B or C. In this case, shares represent an indirect investment vehicle, they are not the investment itself. Don’t try to select companies based on their valuation potential, as that might carry additional risk. Play it safe.

4. Don´t use any funds you may need over the next 5 years. Think of this as an investment for your retirement.

You can find lists of oil ETFs and big oil companies here:

http://etfdb.com/type/commodity/energy/crude-oil/

http://www.investopedia.com/articles/personal-finance/010715/worlds-top-10-oil-companies.asp

We do not recommend any specific shares or ETFs, as this article serves the purpose of presenting the overall opportunity and doesn´t not promote any given company or investment vehicle.

The slump in oil prices represents the investing opportunity of a decade. Other sectors may present better performance prospects, but none with such a low degree of risk. The current risk/reward ratio of oil is just too good to pass on. That´s the Atlantic Perspective.

Atlantic Perspective.

Copyright © 2015 by The Atlantic Perspective.

The Atlantic Perspective is an opinion blog, aimed at explaining and providing solutions to some of the world´s most relevant issues.

www.atlanticperspective.com


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