why I invested in OIL in 2015...

Last weekend I visited a friend's property in East Texas. He has a few oil pumps and the mineral rights for what appears to be a pretty sizeable oil field underneath. However, the pumps were idle. He said that oil prices are so low right now, that the oil companies are not pumping. 

This brings the question-what part does crude oil play at the price of gas we pay when we fill our car gas tank?

(Source: www.gaspricesexplained.com)

From the chart above you can see that crude oil represents only 40% of the price at the pump, while the other 60% include refining (25%), taxes (17%), and transport and retail (18%). While crude oil prices change, the cost of refining it, transporting it, and selling it, for the most part, will not change. Assuming taxes are calculated based on the retail price, then a 1% drop in the price of crude oil will have an impact of 0.4% on consumer price, and an additional 0.068% through taxes (17% of 40%). Total of 0.468%. 

So how much does it cost to produce one oil barrel? It costs $52.50 in the UK, but only $10 in Saudi Arabia and Kuwait. This is why they can continue to make a profit while we don't. In the US, it costs approximately $36 to produce a barrel of oil. This is why the US is not pumping as much anymore. 

There are many theories as to why OPEC countries and Russia decided to pump more and reduce the price. However, there is another interesting dynamic here. The dynamic of supply and demand. Most of the oil pumped will be used to fuel vehicles (cars, planes, ships), which means it has to be refined and delivered. Does a reduction in oil price affect the demand? It does, but very little. 

Let's go to the first lesson in economics: supply and demand. From the chart to the right, you can see that if the price goes down, the quantity will go up (See the red line). Depending on the slope of the line, if the price went down 10%, the demand quantity would go up 10%, so the total budget spent will be the same. Why? because more people will buy if the price was lower (people who never bought before), or people will buy more because they can afford more (people who did buy before). However, think about the dynamics of the fuel market. Will I drive more because prices are lower? Where would I go? Would I change jobs just so that I can drive more to work because I can afford to??? I may take one (or more) extra road trips, but that's pretty much it. Will people who never bought a car buy their first one now? Will I buy a bigger car only because fuel prices are lower? The answer is that the impact of gas prices on the demand is little, which is why the demand curve for oil is much steeper. 

If you look at the chart to the left, you can see the small impact of huge changes in oil prices (blue) between 1970 to 2012 (in the range of under $20/barrel to over $100/barrel) on consumption (red) that barely changed from 60 million barrels/day to under 90 million barrels/day.  While oil prices changed 5-fold, demand increased by 50%. 

So if OPEC countries "flood" the market (figuratively...) with oil to the point they reduce the price per barrel to the $10 it costs them to produce it (without any profit), from the $34/barrel today, they will reduce oil prices by 70%, but the impact on retail "fuel at the pump" will only be 33% (remember, the impact of oil and taxes on total price-per-gallon is 0.468). How much will 33% price reduction impact demand? Even if the demand will grow by 10%, the oil producing countries will suffer a 70% drop in price, as well as 10% increase in quantity, still a total of 67% drop in revenue. But if they did lower the price of oil barrel to their production cost of $10/barrel--they will lose 100% of their profits. 

In fact, last week Saudi Arabia disclosed that 2015 will end with a $98 billion deficit, and 2016 is expected to end with a not-much-better $87 billion deficit, because oil is their main revenue source. You see, they planned their 2015 budget when they were selling oil for $74/barrel, and while expenses "came through", the revenue didn't. If it cost them $10 to produce, the drop from $74 to $34 represents 54% drop in revenue, but 68% decline in profit, and there was no significant increase in demand to compensate for it. Saudi Arabia also announced "radical austerity" measures to cut their budget. How long can they hold their breath?

Every now and then a friend asks me whether they should invest in one stock over another. "This stock is so low right now--it just can't get any lower. It must go up!" History shows us that the only price that stocks will never go under is $0. This is where you lost all the money you invested. It happened before... However, oil is a non-replenishable resource (remember that from elementary school science class?...) Demand for oil, let's face it, is not going away. As we can see from the above analysis, not only that the oil price reduction will not yield an increase in demand--it is also unsustainable for the countries that produce it. Unlike stock--the price of oil will never reach zero. 

Now, this is NOT investment advice. I am NOT an investment advisor, certified or not-certified. I'm also NOT suggesting you do anything, but I'm telling you what I did. When oil got as low as it is today--I bought oil commodities. Can it continue to go down? Maybe. Will it go back up? You bet! Will it reach $50 in the next 10 years, before I retire? Will it reach $70? $100? You do the math. 

 

Sources:
http://www.gaspricesexplained.com/#/?section=strategic-petroleum-reserve

http://money.cnn.com/2015/11/24/news/oil-prices-production-costs/

https://www.washingtonpost.com/news/worldviews/wp/2015/12/31/saudi-arabias-economy-minister-denies-the-new-budget-is-radical-austerity/

http://www.resilience.org/stories/2015-02-05/charts-showing-the-long-term-gdp-energy-tie#