Market Insights: Oil prices - time to fill up? | BetaShares

Market Insights: Oil prices – time to fill up?

BY David Bassanese | 10 February 2016
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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.

oillr

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.”

iea
Source: IEA

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.

5 Comments

  1. Eswaran  |  February 10, 2016

    Excellent post David.

    The main concern with this instrument is correlation in the future with WTI. I know you have previously posted that there is a 95% correlation in the past. This has been in periods of prolonged backwardation. My concern is that like the NSYE listed USO, investment in OOO will struggle in times of contango. How exactly is the management fee going to be earned by dealing with issues of contango in the future? I have read that NYSE listed USL in the past has used graded conversion to front month contracts over a year rather than month to month to help deal with contango. USL performed better than USO in the post financial crisis period as oil shot up.
    Overall, I think the true judgement of how this betashares instrument performs will come in the future when WTI goes through contango. I note volume has stepped up significantly in the past year (for OOO on the ASX) and hope that the management fee is earned when contango happens. It will be a shame to suffer all the downside and not the upside when WTI rises again (like USO investors suffered in 2009/2010).
    Interested in your comments.

    Regards
    Eswaran
    PS I have a small stake in OOO.

    1. BetaShares  |  March 15, 2016

      Eswaran,
      Thanks for your comments. You are absolutely right to be conscious of the issues associated with contango and backwardation. At present WTI futures are in relatively steep contango and the “roll cost” associated with contango should be treated as an additional cost of holding such an exposure. As we will explore in our brand new post (see our blog homepage), an investor needs to be aware of the concept of contango and also be happy with the additional cost it imposes on the investment. Please note that, this notwithstanding, there is no way to invest directly in spot oil and so, if an investor wants exposure to the oil commodity an investment in a fund based on futures is really the only option. For further discussion on this point see http://www.betasharesblog.com.au/crude-oil-ahead-of-the-curve/

  2. Smart ones buy now good oil stocks or compamys now they will have a smile from ear too ear soon LOL

  3. Eswaran  |  February 11, 2016

    Hi David
    You have previously mentioned the 95% correlation of OOO with WTI.
    This has been in backwardation.
    It would be a shame if OOO investors suffer the downturn in oil but do not participate in the upturn that will inevitably follow. How does betashares plan on improving on the performances compared to that of similar ETF’s like NYSE listed USO (which performed poorly duing the post financial crisis period boom in oil prices). Other listed entities like USL in the US have previously spread roll over over a 12 month period.
    Appreciate your opinion.
    Eswaran

    1. BetaShares  |  March 16, 2016

      Hopefully our previous answer covered this off. At present our futures index covers the near month futures contract. This has the benefit of providing a ‘closer’ correlation with WTI but is still subject to the forces of contango and backwardation. We have considered the issues at length in our product development process and each approach has pro’s and con’s. At present we believe the near term futures contract approach is best. Obviously this does mean that investors need to be well aware of the issues with contango and backwardation.

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