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Investors in oil shares heading for disappointment in 2016

I’ve heard a few people discussing the value of crude oil in recent days and pondering whether now might be the right time to buy in.

Since the average investor can’t trade oil directly, they must gain exposure through buying shares in oil-producing companies like Santos Ltd (ASX: STO) and Woodside Petroleum Limited (ASX: WPL), or by buying the Betashares Crude Oil Index ETF-Currency Hedged (Synthetic) (ASX: OOO) ETF which grants currency-hedged exposure to movements in the value of oil prices.

Investors are interested in oil as the value of the commodity is at decade lows, and there’s an attractive psychological calculus to buying something that could fall from US$35 per barrel to $0 versus rising to US$100/barrel.

On the face of it, that calculation becomes even more appealing when you realise that the largest global producers – the Middle Eastern states – are estimated to have production costs of around US$8-20 per barrel, depending on who you ask and what metric they use. Theoretically, that puts some kind of vague floor under the value of oil, suggesting prices won’t fall below those levels for a sustained period of time.

For the sake of argument, let’s say that oil won’t fall below US$15 per barrel. The value of your investment could decline by 58% from today’s levels of ~US$35/barrel. Conversely, if prices went to US$90, US$100, or US$110 per barrel, you could make 257%, 285%, or 314% on your investment respectively.

This is an attractive risk-reward trade-off.  Like many others, I also find the situation intriguing, but we need to draw a distinction between the scale of the potential losses/gains, and the likelihood of them occurring.

Are prices of US$100 a barrel an abnormality, rather than the norm?

This chart shows the average long-term prices of oil (adjusted for inflation). In this context, prices above US$80/barrel during the 1980s and 2000s look like an aberration, rather than the norm.

We must also remember that last decade was characterised by disruption to markets as a result of the war in Iraq, sanctions against Iran, the GFC, and many other factors that possibly resulted in higher oil prices.

Markets are chaotic

And the oil market more so than most, with dozens of nations competing to sell oil. Russia is churning out oil because its battered Ruble makes US$ earnings incredibly appealing. Governments are talking about removing sanctions from Iran, which could see a significant increase in oil supply, again pressuring prices. The US also invested heavily in growing its production to take advantage of high prices over the past decade.

On another front, the recently signed climate change treaty in Paris may or may not have any impact on supply, demand, or prices in the near term.

Supply doesn’t just go up in smoke

Oversupply takes a significant amount of time to clear out, because it can take a long time for companies to go broke. Just look at the iron ore market, which is still comprehensively oversupplied after two years.

In fact, many expansions launched during the heyday of iron ore prices – like Gina Rinehart’s Roy Hill mine – are just coming to completion now, meaning more supply may yet come online.

The oil market is different to iron ore, but in light of all these factors I feel the near-term outlook for prices is more likely negative than positive.

As a result, I am not increasing my exposure to the oil industry, although I continue to hold my shares in Senex Energy Ltd (ASX: SXY), which I bought in a spectacularly ill-timed purchase just a couple of months before prices crashed last year.

Moreover, this article refers specifically to the value of oil the commodity – we haven’t even got started on company-specific risks, such as Santos’ mountain of debt. For these reasons I think investors are better off employing significant caution when considering oil investments.

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Motley Fool contributor Sean O'Neill owns shares of Senex Energy Limited. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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