Are we at an unparalleled historical moment for investing in oil? In recent months we have witnessed one of the most convulsive and complex storms in the oil industry; a storm that has not only sunk the price of a barrel of crude oil but has also achieved something that has never happened before: oil has traded in negative values.
Faced with this unparalleled opportunity, many are considering investing in oil. However, crude oil and its price are subject to a series of conflicts, tensions, and geopolitical dynamics that, due to their complexity, often scare off potential investors.
Fortunately, you have before you an article that, like an executive summary, will give you the contextual keys and the most important arguments to understand the oil market and be able to invest successfully in it. In addition, we will also explain what financial instruments you can use to invest in oil (some of them with 0% commissions).
The essential context to know before investing in oil
The uncertainty caused by COVID-19 and its effect on oil: a unique opportunity for the investor?
The global pandemic affects almost every country on the planet and poses a lot of uncertainty going forward. At present we only know that the economy is still being battered by the pandemic, but we do not yet know how severe the recession will be until we are out of it.
Many expect a V-shaped recovery in the economy. Although at this point it seems more plausible to think that the economy will recover in the shape of the Nike logo; that is, with the economy not returning to pre-pandemic levels until late 2021 or even later.
In any of the above scenarios, there will be new companies entering the scene, many will no longer be around, and others will emerge much strengthened from the pandemic. But, with all certainty, the world economy will continue to need oil in order to continue on its course.
In other words: It is only a matter of time before world oil demand (and, consequently, its price) returns to normal.
Oil and its importance in the world economy
When Edwin Drake discovered oil back in 1864 in the small town of Pithole City, Pennsylvania (USA), he never imagined the repercussion that this vicious black liquid would have on the world, the same one that would later be called from “black gold” to “devil’s excrement”.
The relevance of oil in all sectors of the global economy makes its price an object of obsession in the financial markets. On the NYMEX in New York and in London, the two largest crude oil futures markets in the world, almost 30 times the daily amount of oil that the countries of the planet require to function can be traded in one day.
In October 2016 the size of the crude oil production industry reached $1.7 trillion, almost 3 times more than the $660 billion generated by all other major commodities. In 2019, global consumption averaged 100 million barrels of oil per day.
The world’s oil consumption has done nothing but grow. Indeed, even during the 2008 crisis, oil consumption was barely affected.
Since the first oil price shock in 1973, major economies, especially the US, have been in check when there has been a price spike. As a result, the US has developed hydraulic fracturing or “fracking” technology that pumps water, sand, and chemicals underground at high pressure to release oil and gas.
Fracking is more like manufacturing than traditional oil exploration and production. It is standardized, enjoys rapid productivity gains and the process starts and stops depending on whether the price is above or below $50 per barrel (below that price the expensive process does not pay off). According to the IEA, International Energy Agency, in the USA approximately half of the total crude oil production comes from fracking. Moreover, the Permian Basin, home of the US fracking industry, already produces more oil than the members of the Organization of Petroleum Exporting Countries (OPEC), including Saudi Arabia and Iraq.
Although the global trend is to “decarbonize” and “de-fossilize” the economy, using and promoting new energy sources (renewable, such as wind and solar), it is no less true that oil continues to have a great specific weight in the international economy and will continue to do so for the next few decades until an energy transition from fossils to renewables is achieved in which oil does not have the weight it has in the current economy.
The price war: A favorable scenario for investing in oil?
To understand the conflicts that have occurred recently with the price of oil we need only consider the following aspects:
- In general terms, the price of oil is established by the simple law of supply and demand. The COVID-19 pandemic has caused a sharp drop in demand
- The oil powers continued to extract barrels of crude far in excess of global consumption, causing supply to far to outstrip demand.
- Surplus oil can be stored, waiting for prices to rise again to be sold at a “normal” price. However recently the world’s oil storage limit was reached, which is why oil traded in the negative (you were paid to “take” the barrels, as there was no room to store them).
With that said, how did the recent oil price war break out?
In March 2020, the pact between the Organization of Petroleum Exporting Countries and allies, also called OPEC+ (23 countries in total) failed in its attempt to stabilize global production to adjust it to the real demand that was in the full pandemic. This unleashed a market war between Russia and Saudi Arabia that plunged the price of major blends to levels of $20 per barrel.
They were subsequently forced to cut global oil production by 9.7 million barrels from May 1, 2020, to April 2022. The agreement was not without drama and tension because while most oil companies, private and state-owned, announced cuts in their investment plans for 2020, state-owned Petroleos Mexicanos (Pemex) kept its budget strategy unchanged.
Unfortunately, the oil agreement between OPEC, the energy cartel, and Mexico was a pyrrhic victory as the pandemic continues to grow and demand continues to plummet. As a result, Saudi Arabia recently declared an additional reduction of one million barrels per day as of June 1, 2020. Immediately, the market reacted and prices rose slightly.
As we can see, oil price setting is a complex process and involves both the laws of the market and geopolitical interests. Broadly speaking, the world’s oil-producing powers have played at hurting each other by refusing to cut production (or by doing so too late).
They have maintained an arm-wrestling match to demonstrate their strength, due to which they have sunk the price of a barrel of crude oil and created an ideal scenario for investing in oil.
At this point in the article, we have already established the necessary context. With the groundwork laid, let’s get back to the question at hand: Why should you invest in oil in the middle of 2021?
4 Reasons why to invest in oil right now
1. Mass vaccination before the end of the year and a return to normal oil demand
At present times, it is expected that by the end of 2021 a large portion of countries in the world will have managed to achieve the well-known herd immunity by managing to vaccinate more than 80% of their population. In other words, there are reasons to be optimistic in the medium term.
In addition, almost all world powers and their major pharmaceutical companies are working against the clock producing as many vaccines as possible and improving existing ones to be effective against new variants and strains of COVID-19.
Based on the above, we believe that the drop in oil demand will end at the end of this year, which will imply a rise in crude oil prices per barrel.
2. OPEC+ and Saudi Arabia cuts
The OPEC+ and G20 initiatives will impact the oil market in three ways. All of them are already contributing or will contribute to higher prices for a barrel of crude oil and its direct derivatives:
- The OPEC+ production cut in May to reach the baseline will actually be 10.7 mbd (million barrels per day) and not 9.7 mbd. This will provide immediate relief from the supply surplus in the coming weeks, reducing the peak stock build.
- Four countries (China, India, Korea, and the United States) have offered their strategic storage capacity to the industry to temporarily store unwanted barrels or are considering increasing their strategic stocks to take advantage of lower prices. This will create additional margin for the impending stockpile build-up.
- Other producers, with the U.S. and Canada leading the way, could see a drop in production of around 3.5 mbd in the coming months due to the impact of lower prices. The loss of this supply, combined with OPEC+ cuts, will lead to a shortfall in the market in the second half of 2020.
If production falls sharply and demand begins to recover, demand will exceed supply in the second half of 2021. This will allow the market to begin to reduce the massive excess inventories that built up in the first half of 2020. This scenario will put upward pressure on oil prices before the end of the year.
3. Declining oil production spending will impact future oil supply
Another element to consider in the oil market analysis is the significant decline in companies’ capital spending on exploration and production in 2020. It is estimated to drop by approximately 32% compared to 2019 and will be only $335 billion, the lowest level in 13 years. It is therefore expected that production will not be able to supply demand when demand rises as the world returns to normal. We believe this scenario will unequivocally contribute to higher oil prices per barrel, even at levels above pre-pandemic prices.
4. Oil companies are strong enough to weather the crisis
Let’s look for a moment at Shell, one of the world’s largest multinationals and one of the 4 largest companies in the oil sector: despite a very strong first quarter, Shell cut its dividend in a move that surprised almost everyone. However, management wants to prepare the company for even tougher times, which is a prudent and conservative goal.
Shell has significant debt on its balance sheet, but should not have illiquidity problems for the following reasons:
- It has an AA2 credit rating, which gives it one of the healthiest balance sheets in its industry.
- The company is well-diversified both geographically and in terms of its business units. Thus, refining, marketing, LNG, chemicals, etc., provide significant revenues in times of low oil prices.
- The dividend cut means that Shell will save $10 billion next year, which alleviates the need for cash.
- Because it is a European-based company, Shell benefits from the European Central Bank’s bond purchases, which gives it access to low-interest-rate debt.
- That Shell’s management has decided to cut the dividend, despite its robust balance sheet and solid first-quarter cash generation, raises the question of whether its competitors will emulate it. Shell’s prudent strategy may have a short-term negative effect on the company’s share price–by cutting dividends its shares may appear less attractive to investors– but it adds further strength to the multinational’s medium-term future.
Shell has the highest net debt (adjusted for cash) on its balance sheet at $48 billion. Its peers, BP (BP) and Exxon Mobil (XOM), have nearly as much debt, while Total (TOT), Chevron (CVX), and especially ConocoPhillips (COP) have significantly less debt. Because, in absolute terms, net debt does not say much, it makes sense to measure it relative to assets and/or EBITDA.
On the basis of balance sheet resilience, Exxon Mobil and BP look somewhat weaker than Shell, while Total, Chevron, and ConocoPhillips have stronger balance sheets. All this shows that almost all the companies in the sector are strong and, under the right management, will surely survive once the pandemic is over, which is why we recommend them either through an ETF or by investing in them directly.
How to invest in oil? Financial instruments to articulate the investment
By way of conclusion, we believe it is highly advisable to invest in oil whatever the investment horizon. We consider it very likely that oil prices will be around $90 per barrel by the end of 2021.
In this section, we will see the most common and recommended instruments that we find to invest in oil through the broker eToro. com, an investment platform used by more than 10 million users, based in London and authorized by CySEC and the FCA (the UK regulator).
The first step to being able to invest in oil (and its derivative products) is to open an account with the mentioned broker if you don’t already have one.
Another important point in eToro’s favor is that it offers many of its products with 0% commissions and allows you to add funds to your account immediately by credit card, Paypal, or bank transfer (among others).
In addition, eToro has successfully passed our verification and audit process: which means that it has all the guarantees, security, reliability, and liquidity standards that we demand from a broker to successfully pass our high standards.
With this first step completed, let’s see what financial instruments we have available to articulate oil investment and take advantage of this historic moment in which we find ourselves:
a) Direct oil investment via CFD (minimum investment: $200)
A direct method of investing in oil is through the purchase of contracts for difference (CFD) for oil. The CFD OIL (https://www.etoro.com/markets/oil/) gives us direct exposure to the price of a barrel of crude oil, whose price replicates by directly tracking the price of a barrel of West Texas Intermediate, the benchmark for setting oil prices.
CFDs are financial products that allow leverage (investing more money than we actually have available) and have variable custody fees. Therefore, investing in oil through CFDs is a recommended option for those with a speculative profile and a near horizon, who wish to hold their investment for a short period of time and be able to invest more money than they have through leverage.
b) Direct investment in oil through ETFs
Another direct method of investing in oil is through investing in oil-based exchange-traded funds (ETFs). ETFs are listed on a stock exchange and can be bought and sold in a manner similar to stocks. For example, buying one share of the U.S. Oil Fund (USO) gives us exposure equivalent to one barrel of oil.
To check the minimum investment of the United States Oil Fund ETF go to: https://www.etoro.com/markets/uso.
In other words: being a product that gives us direct exposure to the price of West Texas Intermediate oil is highly recommended for all those with an investor profile and a medium to long-term horizon. For most readers, this product may be the most recommendable option as it has less risk as is not a leveraged product.
c) Investing in oil indirectly through shares of oil companies
As mentioned above, almost all companies in the sector have very resilient balance sheets and are implementing a very sound capital structure and dividend policy. Many of these companies have significant growth expectations in the coming years, especially when the engines of the global economy return to their “nominal speed”.
It is worth mentioning that although investing in these oil companies does not give us direct exposure to oil, the share price of these companies maintains a strong correlation with the price of brent barrels.
Despite the dividend cut, Shell looks like a solid value picks and represents a good chance, for any portfolio, of achieving a good return over the long term, mainly because its share price in the market (about $30 as of writing) is well below its intrinsic value. We recommend it with a target price of $65 per share at the end of 2024.
For investing in Shell through eToro we find that there are 2 variants of Shell shares available: RDS.A and RDS.B. Both are the same Shell shares, but type A (RDS.A) is subject to dividend tax in the country of origin. Therefore, as a general rule and is located in Spain or Latin America, it is more advisable to choose type B (RDS.B): https://www.etoro.com/markets/rds.b.
Of course, at eToro, we also have the option to invest with 0% commissions in the world’s leading oil companies, such as BP (you can find it under the symbol BP.L), Exxon Mobil (symbol XOM), Total (FP.PA), Chevron (CVX) and ConocoPhillips (COP), among others.