• Matt Davis

Can Oil Come Back?

“Crude is gushing from the ground at the rate of 66m barrels a day, half as copiously again as in OPEC’s prime. The world is awash with the stuff, and it is likely to remain so.” — The Economist, “Drowning in Oil”

It has been a rough year for oil and frankly for commodities in general. We are seeing lots of quotes like the one above forecasting a never-ending cycle of price drops. What is interesting about this particular quote is that it actually comes from March 4, 1999. During that spring, oil was trading between $10-15/barrel. However, despite the concerns of oversupply, it turns out that bottom of the market had actually occurred the fall before and oil prices would increase to well over $140 over the next decade before coming back down during the financial crisis.

Source: "Crude Oil Price History Chart." Macrotrends. 2015. http://www.macrotrends.net/1369/crude-oil-price-history-chart

I would not venture to bet that oil will skyrocket like it did during the last decade. There are many headwinds including a slow-growth world-economy and soft inflation. However, what history has taught us is that markets are naturally self-correcting and supply and demand will most likely come into balance. Already over 50% of rigs have been shut down in the United States.

Energy stocks have felt the brunt of lower oil prices, dropping 40% off their highs. While this has been in large part a reflection of lower earnings, valuations are also shrinking. The energy sector is now trading at 1.4x book value, which is nearly 50% cheaper than the overall market and one of the largest discounts of the past decade.

Does this mean we are at the bottom? Not necessarily. Weakness can continue to show up in unexpected ways in the world economy. However, it is an impossible task to decide when the exact bottom will occur until well after the fact. Being early can be painful, but for those with a long-term investing horizon, the discounted valuations could pay off over the entire cycle.

"Can Commodities Come Back?" Blackrock. September 2015. https://www.blackrock.com/investing/literature/market-commentary/outlook-for-commodities-market-perspectives-september-2015.pdf.

"Drowning In Oil." The Economist. March 4, 1999. http://www.economist.com/node/188131.

#oilprices #worldeconomy

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