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Is now the time to invest in oil?

Investors in oil have not had a good year. Demand for oil has collapsed, partly from a lapse in overall demand due to the pandemic, but also because airlines aren’t flying and fuel sales have plunged. Meanwhile OPEC has tried to cut production, but this has not succeeded in driving prices higher.

And yet a look at oil ETFs shows that fund share prices are exceptionally low. For example, Credit Suisse X-Links Crude Oil Shares Covered Call ETN has seen its share price drop from $20 in January 2020 to less than $5.00 today.

Wouldn’t it make a lot of sense to grab these shares now?

Or would it? It would only make sense if you believe that the price of oil is going to rise again, and that demand for oil is going to grow back to pre-crisis levels.

Within the industry itself, there is no consensus about this. Uncertainty stems from the fact that the pandemic is just not under control yet in many places around the world, warns Royal Dutch Shell’s chief executive Ben van Beurden at the company’s. Q2 earnings call last week.

“And everybody who can tell you certain things with certainty, I think you have to take with a great pinch of salt. And of course, we don’t know how this pandemic is going to work out. I hope it will work out well,” Beurden complains.

Some analysts do believe that demand will come back rapidly once the pandemic is behind us. “Low oil prices will help oil demand growth when the world puts the pandemic behind it,” insists Michael Lynch, an expert on petroleum economics and energy policy. In many of the previous bust cycles in oil, oil demand growth has accelerated after major collapses in prices, Lynch maintains.

“In the medium to long-term, oil prices will bounce back — such is the nature of this cyclical, boom-bust industry. The advent of COVID-19 epidemic has added a twist to the to the natural cycle of things, however,” according to Lynch.

Typically, oil prices can only drop so low before demand for cheap oil by growing economies rallies prices upwards. But today, with global consumption cut by 30 per cent  and storage capacity near its maximum, demand is not there to save oil prices just yet.

Other analysts are not so sure.

“In reality, the future of oil demand will likely be a mix of three scenarios, the ‘full recovery scenario’, the ‘go it alone’ scenario with a deeper downturn and slower trend growth thereafter, and the ‘greener growth’ scenario,” writes oil industry expert Tsvetana Paraskova.

“Reality is likely to mix and match different elements from these scenarios. Some regions will push hard on the accelerator for the energy transition, while others focus more on developing domestic manufacturing industries and protecting existing energy producers. But most of the likely changes work in the same direction: towards weaker oil demand growth,” agrees an analyst at Wood MacKenzie says.

The International Monetary Fund (IMF) also has a gloomy forecast for oil demand growth.

“The price of crude oil has fluctuated in recent months and is expected to be 41 percent lower in 2020 than in 2019. The decline in the volume of oil imports in economies affected by the pandemic has also been substantial, with global oil demand expected to be about 8 per cent lower in 2020 than in 2019. The overall estimated direct impact on oil trade balances ranges widely across economies—from –7 percent to 3 percent of GDP—reflecting differences in dependence on oil exports and imports,” the IMF report shows.

Does this mean that any investment in oil must be on an extreme long-term basis? To be sure, a number of analysts point to factors in the economy that suggest the contrary.  For example, in almost every developed country consumers are using their cars far more than in the past, as they prefer not to risk infection on public transport.

Then, demand for oil has recovered in India and China. “Oil demand in China recovered to nearly the year-ago levels in April. Similarly, the demand in India recovered in May, though it’s still down year-on-year. Looking at the global trends in easing of lock-down measures, the International Energy Agency expects a boost in oil demand in the second-half of the year,” notes analyst Rekha Khandelwal.

All of these factors are important, but the real challenge for the oil industry is to stay profitable with the price of oil at low levels. The oil price volatility in the past year had devastated the US shale oil producers who cannot meet expenses when the price of oil drops below a certain level. But the low price affects all oil companies: Only those who can survive with oil at $40 or less are likely to be good investments.

This means, for investors, that evaluating an oil ETF involves a close and hard look at all of the companies in the basket. For example, an ETF that focuses on midstream oil companies might have too many companies with high levels of debt. Highly-leveraged companies in this period of revenue pressure have less chance of surviving than those with well-rounded balance sheets.

Also, some ETFs offer direct exposure to the price of oil, and these are probably not a good choice in 2020. As we’ve seen, there is little chance of oil rising sharply in price.

A much safer choice would be ETFs that are linked to indexes – the Bloomberg WTI Crude Oil index is tracked by a number of exchange-traded funds.

We look at ETFs because they provide the simplest and cheapest access to the oil commodities market for retail investors. It is possible, on many foreign exchange trading platforms, to invest directly in oil futures. Don’t do this, however, unless you have a cast-iron stomach and can afford to wave good-bye to your investment funds without a tremor.

 

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