There’s no doubt oil prices have dropped a long way in recent months. Of course, that begs the question of whether oil prices are near their bottom and worth buying from a medium or long-term investment perspective. Although picking exact market bottoms is fraught with difficulty, from an historical perspective it would be unusual if oil prices fell a lot further from current levels and then held at these lower prices for an extended period. As a result, from a risk-return perspective, averaging into oil exposure by buying into further market weakness could potentially offer long-term rewards. What’s more, it’s never been easier for Australian investors to gain exposure to oil prices through exchange-traded investment products.
Real Oil Prices are Reaching Historic Lows
Oil prices have fallen a long way in a short space of time. As seen in the chart below, in real terms, oil prices have rarely been lower. Indeed, since the spike up in oil prices in early 1974, the real oil price (deflated by 2015 US consumer prices) has only held below $US30 for 14% of the time. The average real oil price since the early 1970s has been $US58.
Another factor to consider is that real oil prices have fallen by around 70% since their recent peak of $US108 in June 2014, which is broadly in line with the 70% decline between June and December 2008 during the financial crisis. Even during the much longer oil price retreat from May 1980 to March 1986, real prices still fell by a cumulative total of only 80%.
All up, history suggests oil prices have now reached unsustainably low levels, with the magnitude of the recent correction also on a par with the previous worst oil price retreats over the past 45 years.
The Supply-Demand Imbalance will be Eventually Resolved
Of course, underpinning the weakness in oil prices of late has been the excess of supply relative to demand. Most particularly, the upsurge in supply, due largely to the rise in US oil production, a recovery in supply from war-torn Iraq and most recently the lifting of embargoes which will also allow Iran to export more oil. According to the International Energy Agency (IEA), global oil supply rose by a “hefty” 2.6 million barrels per day (mb/d) in 2015, following equally strong gains of 2.4 mb/d in 2014. As it was, growth in demand was also solid, growing by 1.8 mb/d last year – though this was not enough to stop total supply in 2015 exceeding demand by more than 1 mb/d for the second successive year.
According to the IEA’s January Oil Market Report, unless supply is cut back more forcefully than currently projected “the oil market faces the prospect of a third successive year when supply will exceed demand by 1.0 mb/d and there will be enormous strain on the ability of the oil system to absorb it efficiently.” A key challenge is the fact the IEA expects US production to only decline by around 0.7 mb/d this year – to be only back to the levels prevailing in 2014 – which will be broadly offset by higher supplies from Iran. As has been widely quoted, the IEA Report concluded “unless something changes, the oil market could drown in over-supply.”
Of course that begs the question: will something change? Quite possibly yes. For starters, in the face of depressed prices, there may well be greater cutbacks in US production than the IEA currently envisages. One reason is that many US producers were protected from falling prices last year by timely price hedges – but many of these hedging contracts will be expiring this year – leaving producers more exposed to low prices. What’s more, many US producers benefited from credit extensions which allowed them to keep producing at a loss in the hope that oil prices would eventually recover. But with rising risk spreads in the energy segment of the junk bond market, rolling over debts to stay in the game should become much harder.
At the same time, oil industry consultancy Wood Mackenzie has suggested that “only” 6% of global production fails to cover operating costs at an oil price of $US30. But even if only half of this uneconomic production (i.e. 3% of global production) were cut this would amount to 2.8mb/d of global supply – or more than enough to better balance the market this year (remembering that excess demand has been estimated to be 1.0 mb/d).
It’s never been easier to get Oil exposure
Thanks to the advent of exchange traded funds (ETFs) on the Australian Securities Exchange, it has never been easier for investors to gain exposure to oil. The BetaShares Crude Oil Index ETF – Currency Hedged (Synthetic) (ASX Code: OOO), for example, provides investors with exposure to the performance of crude oil without the need to directly trade in the futures market or even undertake the costly exercise of actually buying and physically storing oil themselves.
Instead, the Crude Oil ETF seeks to track the S&P GSCI Crude Oil (Excess Return) Index, which in turn tracks the performance of West Texas Intermediate (“WTI”) crude oil futures contract after allowing for net financing costs. What’s more, the Index employs a AUD/USD exchange rate hedge so that the Fund more closely tracks the $US oil price while substantially offsetting exchange rate risk.
Of course, while the use of futures in this way is a very efficient means of gaining exposure to commodity price trends, the Fund does not track the spot price of oil directly due to the additional costs associated with maintaining a futures position (namely the need to sell expiring contracts and buy new ones with a later expiry date, in a process known as “rolling”). For more information on these costs, please see our FAQ.