Oil’s Cheap, So Now What?

mugato oil

Yes. I know I’m using the meme incorrectly. Please don’t email me about this.

The price of oil continues to fall, and it won’t be long before investors and the media will be asking whether it’s time to load up on energy within portfolios. Right now the primary focus is on how low the price can get, with current estimates suggesting that $30/barrel is not out of the question, and some predictions claiming it could go even lower. So when is the right time to buy, and how much of a portfolio should be allocated to energy?

These are good questions, but not for the reasons you might expect. Answering those questions mindfully should help any investor better understand the underlying assumptions that go into making smart investment decisions. For instance, why should a $30 barrel of crude be an attractive price to buy? Superficially we assume that it’s a bargain: the price was $100, now its $30, so you should buy some. But what should matter to an investor is not the new price but whether that price is inherently flawed. The sudden drop in the price of oil may lead us to believe that oil is too cheap, but if so what should the proper price be? Determining what a fair market price should be can be challenging, one matched only by trying to figure out when the price has actually bottomed and won’t go any lower.

Capture

But say you feel comfortable that the price of oil has reached its final low and is significantly undervalued, you’ve still yet to figure out the best way to participate in the rebound. For instance, are you going to invest in individual oil companies, or will you purchase a mutual fund that buys a basket of various energy firms? If the former, what kind of companies do you want? Big energy firms like Shell and BP, or some of the very small producers? Will you be buying into shale oil, tar sands, or investing in energy production farther afield?

If that feels too complicated a set of questions to answer you could always buy an exchange traded fund (ETF). ETFs have become quite common today as a method to passively have your investments mirror various indices, but they were initially a way to simplify investing in commodity markets. So rather than focus on the companies that will extract the oil, you’d rather invest in the price of the barrel itself. That has the advantage of removing any extensive analysis that may be needed to be done on a company (profitability, type of oil investment, liabilities), but carries the down side of significant volatility.

MI-CH372_OILfro_DV_20150119163357Getting over all those hurdles leaves only the question of how much of a portfolio should be allocated to the energy sector. The answer here is as frustrating as all the rest, it will depend on how much volatility you can stomach. If you are encroaching on retirement, a good rule of thumb would be not too much (if at all). If you are very young and aren’t intending to use your investments for sometime you can presumably accommodate quite a bit more.

After all that the only thing left is to have the price rise. What could stand in the way of that? Perhaps a prolonged battle for market share that sees a continued lowering of the price, or even nations not sticking to their assigned production targets. Maybe an international treaty that could see a former energy producing nation reenter the market place, flooding it with cheap oil. An extended slowdown in a significant economy might also reduce global demand, prolonging the lowered valuation. Even the arrival of new technology could displace a portion of the market driving down future oil requirements. Or the simple knowledge that proven reserves are abundant can remove market concern of future shortages. In other words, lots of things can still prevent a rapid rebound in the price of oil.

The point here isn’t so much about oil but about more clearly seeing the risks that underlie “sure thing” opportunities. There is no easy money to be made in investing. Opportunities, no matter how superficially guaranteed they may seem still come with dangers that shouldn’t be ignored. Cheap buying opportunities can be good, and if they make sense should be pursued. But all investing comes with risks and not being aware of those risks can lead to serious mistakes in the management of a portfolio. More than one competent investor has been badly burned over-estimating the likelihood of a significant rebound. The lesson is don’t let your lust for opportunity crowd out sound investing strategies.

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