Oil Price Dips Might Lure Investors Hoping to Field Some Profits

Electric and hybrid auto sales are gaining momentum. Alter-native energy sources continue to become more efficient and affordable alternatives to fossil fuels. But the global economy still relies heavily on oil and changes in oil prices have complicated effects on the stock market.

That became abundantly clear when Saudi Arabia opened its oil spigots in March 2020 as retaliation against Russia’s refusal to cut production. A coordinated cut in production would have helped maintain a floor on oil prices during the coronavirus pandemic and put a dent in U.S. shale oil production. After Russia refused, Saudi Arabia unilaterally cut U.S. bound oil by $7 a barrel and by $8 for oil slated for Northern Europe in a targeted move to erode Russia’s market share. That was a slap heard round the world. On March 9, 2020, global oil futures were down by around 20% and Dow Jones futures indicated a market down by yet another 1,000 points after an already rough start to 2020.

Whether Saudi Arabia’s gambit goes into the his­tory books as a blip or the first salvo of a prolonged battle over global pricing, oil supply and demand shocks occur frequently. Usually, they are minor. A large refinery could break down or economic growth could slow and dampen demand. Because shocks are prone to come up again, stock investors should learn who is affected by production cuts or gluts. Though they can make for some mildly exciting headlines, oil price fluctuations should be viewed in the same context as economic cycles: They happen, they are expected and they might lead to compelling buying opportunities.

What Keeps the Oil Markets Pumped Up?

Before we think about stock prices, let’s refresh ourselves on the structure of the oil markets. The United States is the world’s largest oil producer. In 2018, we produced close to 18 million barrels a day or about 18% of global production, according to the U.S. Energy Information Administration. Unfortunately, we’re also the largest oil consumer in the world. We used 20 million barrels a day that same year.

The two next largest producers are Saudi Arabia, with 12% of the global market share, followed closely by Russia, which produces 11%. Russia consumes 4% of the world’s oil and Saudi Arabia uses only 3%. So, unlike the United States, Saudi Arabia and Russia are net exporters. Any price cuts have adverse effects on both countries’ incomes. Price wars affect every country, company and household in the developed world and have spillover effects everywhere else.

U.S. households generally benefit from lower oil prices. Lower gas costs free household budgets to buy more goods and services elsewhere (larger SUVs, for example). Cheaper gas also benefits airlines, cruise lines and the transportation industry. Naturally, some of these positive effects are offset by job losses in the domestic energy industry. When prices fall, production becomes less profitable and firms lay off workers. Upstream firms — those involved in exploration and production — are most vulnerable, while pipeline companies and partnerships that bill by volume might even benefit if demand picks up. Downstream retailers are less likely to be negatively affected.

Net exporting countries like Russia and Saudi Arabia are exposed to sudden price shocks and both of those countries are huge exporters. Sixty percent of Russia’s gross domestic product came from energy in 2017. Loss of oil income will have compounding effects on the Russian economy. There will be layoffs as unprofitable production slows, and, as we saw in the last Russian oil crisis, the ruble will collapse, leading to inflation in the cost of imported goods.

The Russian government is estimated to need oil to be at $51 per barrel or above to balance the budget. Though Russia has maintained a meager debt/gross domestic product ratio of only 12%, its resilience will still be tested if oil prices stay around $30 per barrel. The Russian government is aware of its exposure to energy prices and has been accumulating funds to offset losses in tax revenue.

Saudi Arabia is, of course, also dependent on oil exports for its economy. Oil and gas represent 50% of its GDP. Though cutting prices might seem counter to the kingdom’s interests, the action appears intended to scare Russia into compliance. Ultimately, oil prices depend on oil exporters negotiating coordinated production levels. Otherwise, every producer would flood the market simultaneously in the short term and drive the price down to uneconomic levels.

The Organization of Petroleum Exporting Countries (OPEC), along with other countries that coordinate production alongside it, also faces the possibility of members occasionally cheating by exporting more than a current agreement permits.

Shares of Aramco, the Saudi Arabian state-owned petroleum company and the world’s largest initial public offering, were hit by the supply cut. Aside from the immediate oil price concerns, shareholders have to worry their investment capital isn’t being appro­priately managed. Many U.S. petroleum companies won’t be quite as exposed as Aramco due to their vertical organization of owning upstream, midstream and downstream assets, but they can still become mighty volatile.

Now We Spill on What to Do Next

You shouldn’t be panicking, because you are already diversified enough to weather energy prices — or any other industry-focused risk — going south. If you aren’t, shame on you and you should address that at your earliest opportunity.

That said, review your port­folio to see if any of your stocks are heavily exposed to oil prices and in so much debt they might have diffi­culty making debt payments. If they are and the oil supply shock shows no sign of abating, then get out. There will be other times to be a buy and hold hero.

After you’ve checked through your portfolio, focus on buying opportunities. Like any cyclical stock, the best time to buy energy is when the cycle is declining but not quite at the bottom, since investors will tend to bid prices up in advance of any rebound.

Look for attractive dividend yields on big energy companies and, if they are suitable for you, some limited partnership interests. Take the plunge if the payout ratio on those high dividends is relatively low and they expect that low ratio to remain stable.

Be careful. U.S. shale producers might be in for a tough time or even be forced into bankruptcy if they can’t sell their product for more than their break-even price (around $50-80 per barrel).

Conventional oil producers have break-evens closer to the $30-40 range. Saudi Arabia’s break-even is estimated to be closer to $10 per barrel, which might account for its willingness to play chicken with Russia.

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This article was originally published in the May 2020 issue of BetterInvesting Magazine.


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