Oil is a popular topic due to its surprising ~60% price drop from June 2014 to 1Q2016. Nobody could have imagined such a quick collapse in oil. I certainly didn't when I decided to buy a Honda Fit instead of a Jeep Grand Cherokee Limited last summer! If I had known I could pump my rolling 4th bedroom for less than $2.50 a gallon, I might very well have opted for the bigger car.
Given knowing what the hell is going on in the world is part of being a functioning citizen in today's society, I decided to do some research into what happened. After all, I did purchase the oil ETF USO, a couple major integrated oil companies, an airline stock, and some auto stocks in my newest diversified investment portfolio for 2015 to try and make some money.
So what caused this significant drop to ~$30/barrel, and how does this affect businesses, the economy, and our everyday lives? Is oil poised to rise once again? Let's explore these questions and more.
Contributing Factors To The Decline In Oil Prices
There's no single, clear-cut answer as to why the price of oil has been dropping. As with other important occurrences in history, there are a wide variety of reasons for the decline. Here are four of the reasons.
1) Declining Demand
Even though the financial crisis is over, the current state of the economy is below where some hoped it would be by this point. The economic outlook for 2016 is tepid, especially now that the Fed has raised rates, acting as a breaking mechanism for growth. Low oil prices can very well be a signal for weak global demand. Weak global demand may lead to weaker corporate profits, which leads to a decline in the stock market. Everything is rational in the long run. If there was robust demand, oil prices would be higher. Demand is also lower due to increased efficiency, and a growing switch to other energy sources.
2) Turmoil is not affecting output
While there has been political turmoil in Libya and Iraq, their production of oil at nearly 4 million barrels a day has not slowed down. Despite the tension, these two countries combined are still managing to produce four million barrels of oil every day. If there were to be a significant drop in supply in their production, oil prices could rise. However, the markets do not appear to be anticipating a large drop in supply due to the geopolitical risk between Iraq and Libya at the moment.
3) America has become the largest oil producer
If one was asked to list the major oil producers in the world, America may not come to mind. But the truth is the U.S. is now the biggest producer of oil, overtaking Saudi Arabia and Russia. We've been extracting energy from shale rock with a fury. Each day, the United States produces over nine million barrels of oil, which is approximately 12% of the total world’s oil production. Since the U.S. does not export crude oil, and is importing less, there is more U.S. supply and decreased global demand. This has naturally led to oil price declines in the U.S. markets.
4) The Middle-East has not curbed supply
In addition to the United States’ increased production of oil, the Middle-East (via OPEC) has also decided not to limit their production of oil either. Since it's cheap for countries like Saudi Arabia to produce oil – for as little as $5-6 per barrel – their concerns for production costs are minimal. Saudi Arabia also has an estimated $900 billion in reserves. There is limited incentive to reduce their reserves since other countries would likely benefit more if they chose to curb supply.
What Products Are Made From Oil?
Oil is an input cost for a tremendous number of things I bet many people don't even realize. Let’s start out in the kitchen. Here are some everyday items that can be manufactured using oil:
- Coffee pots
- Drinking cups
- Egg cartons
- Dish sponges
- Formica counter tops
- Ceiling tiles
- Trash bags
- Cooking utensils
Other areas of interest that can be comprised of oil:
- Car dashboards
- Windshield wipers
- Brake fluid
- Memory chips
- Roof shingles
- Guitar strings
The list really could go on and on. Basically, oil is used to produce plastic, textiles, data devices, and even steel. Thus, one can start to see how oil is an important commodity for many more reasons other than just moving one’s car or private jet from Point A to Point B.
Which Countries Are The Major Oil Producers?
Since the U.S. produces more oil than anyone else in the world, the Middle-East is no longer the oil producing powerhouse that it once was. As of 2016, the top 5 countries that produce oil are the United States, Saudi Arabia, Russia, China, and Canada. Together, these countries produce over 47% of the world’s oil supply.
However, while the Middle-East may not produce the amount of oil that it used to, their reserves more than make up for it. OPEC (Organization of Petroleum Exporting Countries) currently houses 81% of the world’s proven oil reserves, 66% of which are in the Middle-East.
The History of Oil Prices
The United States has seen two noteworthy oil price spikes in the last 50 years. The first is often referred to as “the energy crisis of the ‘70s,” when the U.S. was consuming a huge percentage of the world’s energy as a proportion of its population. Domestic oil production was decreasing, which made the U.S. overly dependent on foreign countries to supply us oil. Not surprisingly, this led to an OPEC oil embargo on the U.S. (also for political reasons). Supply was immediately limited and the price of oil shot through the roof.
In 2008, the second spike in oil occurred (as seen in the chart below); only this time the reason was not as easily deciphered. There was an apparent oversupply of oil in the U.S., but reports of Iraq cutting off the U.S. from their oil supply, and talk that oil could soar toward $200 a barrel, was apparently enough to quickly send the price of oil skyrocketing. After the dust settled, and as the economy worsened, the price of oil overcorrected and landed at a lower price than when the spike first began.
The chart above shows a distinct similarity between the aftermath of the ‘70s and the oil price trends today. If the trends repeat themselves, oil prices may continue to fall in the short-term, and then could level out in the longer term. Of course, as many have witnessed in the past, a slight economic shift or political embargo could easily disturb the trends.
The Various Ways to Invest in Oil
One of the easiest ways to gain exposure to oil is through oil ETFs. Here's a list of the 10 most popular ones below.
In my after tax investment portfolioI decided to buy USO, Exxon Mobile, and Chevron Corp for a 12% overall weighting. For comparison, the S&P 500 has a roughly 10% weighting in the Energy sector. In essence, I'm overweight Energy after the decline. Remember, when you're building a diversified portfolio that is trying to beat some index of your choosing, it's important to think in relative weighting terms.
Black Gold: If you want to play the recovery in a more conservative manner with large cap, integrated energy plays with high dividend yields and large balance sheets. Some of the current holdings include Exxon Mobil, Royal Dutch Shell, Chevron, BP, Total, ConocoPhilipps, PetroChina and many others.
Shale Oil: If you want a more speculative oil motif with much higher beta. New horizontal drilling practices, including fracking, have greatly expanded the ability of US producers to profitably recover crude from domestic shale reserves. This motif’s holdings include Hess, Pioneer Natural Resources, Murphy Oil, Bonanza Creek Energy, Continental Resources, Apache, and more. This motif is down 24% over the past one year has a 0.8% dividend yield, and trades at 45X P/E.
Frack Attack: This motif contains stocks of companies that provide fracking technologies and services to oil and gas developers. Hydraulic fracturing technology has breathed new life into the natural gas industry, boosting production and driving down prices – even as environmental concerns mount. Natural gas could supply 25% of US energy needs by 2035. Names in this motif include Halliburton, National-Oilwell, Kirby Corp, Helmrich & Payne, FMSA Holding. The motif is down 28% over the past 12 months, but has a 1.9% dividend yield and trades at a surprisingly low 14X P/E multiple.
BUILD KNOWLEDGE AND THEN INVEST
Perhaps the need to build knowledge is the reason why more people don't invest. Furthermore, you can gain all the knowledge in the world and still get your investments wrong. Because there's $10,000 at stake of my own money, I spent a lot of time thinking about the investment back story behind each of the 30 positions. It's much different if we're talking play money or when money is given to you to invest.
Now you know four reasons why oil prices collapsed, why oil is important in our day-to-day lives, who the world's largest oil producers are, the 11-year history of oil prices, and how to potentially profit from oil in case of a rebound. The question everybody is wondering now is whether oil prices will stay at these low levels for an extended period of time, go lower, or rebound higher.
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About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $175,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2019 and beyond.