• Saahil Menon

Diary of an Oil Crisis: Where Are Prices Headed?

Updated: Mar 27, 2020

A brief insight into the recently decimated industry...

From 65 bucks a barrel down to a meager $21, oil price movements have once again astounded the financial markets.

The coronavirus has plagued demand for oil, and the simultaneous price-war between Russia and Saudi Arabia has oversupplied the market completely.

A demand and supply shock at the same time: the first of its kind.

The unprecedented nature of these events has caused many investors to debate whether betting on oil would be a profitable decision for the long term…or if oil is heading towards $10 per barrel instead.

Consider our argument to where these prices might be headed below.

1. Short-Term (1-3 months from now)

Looking at the next few months, it seems unlikely that demand for oil will escalate given the growing restrictions on travel and tourism.

With most international airlines canceling at least 75% of their flights, the demand for oil has almost never seen such a shock in market history. The uncertainty of this is the main reason why the short-term desire to buy oil will most likely keep at low levels: an assertion that was reciprocated by Morgan Stanley and Goldman Sachs, as both major banks recently reduced their oil price forecasts by over 30%.

Key Point: Despite the likelihood of a lengthy period of cheap oil, there is a small glimmer of hope. If Saudi Arabia and Russia are able to return to the negotiation table and agree on an output cut, supply of crude oil in the market would fall and therefore push prices upwards. The increase in price here may not be monumental – as the consequences of the coronavirus still loom over oil – but a resolved price war would potentially prevent oil from dropping even further.

2. Medium-Term (3-9 months from now)

The outlook for the second half of 2020 seems more optimistic, with most financial intermediaries predicting that we will see a rebound in the markets here.

The move towards warmer weather - scientifically – suggests a slower outbreak of the virus, which is giving investors the optimistic view that travel will begin to pick up once more along with the prospect of economic growth. Both of these consequences will likely yield higher oil prices (due to higher demand), and this is why we could be seeing WTI Crude returning to the levels of $53-$55 per barrel.

Despite the optimism, this chain of events is contingent upon the virus’ spread slowing down: an important assumption to consider, and one that also emphasizes the high risk associated with current investments into oil.

Key Point: Given the high risk, high reward always tends to follow – and here is where the “V-curve” recovery comes in.

Figure 1: V-Curve Recovery (December 2018)

Source: (Etoro, 2020)

This type of trajectory occurs when a market crash is based on an event rather than a fundamental problem (such as President Trump's first issues with China, in 2018 above). The extent of these market drops are attributed to the fear of an economic fallout rather than actual figures, and this is what causes all asset values to plummet so rapidly.

However, with these types of "event-based" crashes - which is what the coronavirus situation represents - financial markets tend to recover equally as fast, as shown above. Even with potentially lower GDP, a slowdown of the virus or a permeable vaccine would stimulate investor sentiment and therefore trigger growth in the financial markets.

As esteemed professor Mohamed El-Erian said last week: "Financial markets will always turn first...and overshoot", and this is why we can expect a quick recovery in stocks even before we see a solid regaining in economics.

3. Long-Term (1-5 years from now)

Considering the bigger picture, the investing community is somewhat divided between bulls and bears. One side sees the demand for oil assuredly decreasing given the movement towards clean energy, whereas for the other side, it’s still difficult to imagine a thriving economy without oil.

This is why it seems likely that the next few years will still see decently strong oil prices, but the rate of growth year-over-year may decrease. A Bloomberg article recently found that the energy sector’s weightage in the total sales of the US market has rapidly decreased in the past few decades: with oil companies making up 28% of the S&P500 index in 1980 but less than 5% last year.

Figure 2: Energy Weightage in the US Market

Here, we can see that demand for oil is still present, but its relative growth has slowly been waning as the market moves towards alternative sources of energy.

So…Who is this Investment For?

Given the volatility and risk associated with oil investments, those who are just beginning their investing journey and more risk-averse individuals should perhaps keep their distance. Instead – if the aforementioned group of people still seek some action in oil – looking at blue-chip companies such as Chevron or ExxonMobil will allow for potentially less volatility whilst simultaneously paying you 10% dividends: pure passive income at a diluted risk level.

On the other hand, young investors who have a little more experience in the markets and are suited to handle volatility may be more interested in pursuing oil as a commodity: it’s largely based on macroeconomics and can prove highly rewarding for those who get it right.

But, how many young and eager earners get it "right"?

Right or wrong, the lessons learned from investing young are unparalleled, and looking into the dynamics of the oil market will perhaps teach the most painful - yet valuable - lessons of diligence, experience, and patience.