Oil is cheap but still not a bargain as risks loom over market outlook

Oil has dropped 20% to a four-year low since Trump took office-but that still doesn't make it a bargain

By Javier Blas

 

Back in May 2020, the head of a top commodity trading house said he had been placing large orders for oil futures without looking at his screen for the latest price. "Please, don't ever quote me saying that," he told me. "I would look like a fool." The executive wasn't one, though.

 

At that point during the pandemic, oil prices had declined so much that forward contracts for delivery two, three or five years later were a screaming buy. One didn’t need to check for the latest movement up or down. Fast forward to today, and the question is whether oil now has reached a similar buy-first-and-ask-questions-later moment? The answer: not even close. 

 

 

Just because prices have fallen 20 per cent to a four-year low since President Donald Trump arrived at the White House doesn’t mean that oil is a bargain. It does mean, however, that it’s cheap. Historically, one can argue that it is, in fact, very cheap.

 

At around $60 a barrel, West Texas Intermediate, the US benchmark, is trading at a similar level as it was 20 years ago. And that’s in nominal terms. Account for inflation, and oil, in real terms, is trading at the same level as it was more than 40 years ago.

 

But oil futures can still drop further. What’s cheap could become cheaper. Right now, the market is pricing in an economic slowdown and more-than-expected OPEC+ production. But oil traders aren’t pricing in either a recession in America — let alone in China — or a full-blown Saudi-instigated price war. And they aren’t pricing a combination of both a recession and a price war. If those risks materialized, WTI can easily drop below $50 a barrel well into the $40s and even the $30s. 

 

Another question, though, is whether oil can drop below $50 a barrel — so, about $10 below where it traded on Friday — and stay there for a long period, measured in years rather than months. The answer is almost certainly “no” because supply and demand will rebalance quickly at those levels. And that opens investment opportunities for the brave if prices decline a bit further. For those with the stomach to weather significant but temporary mark-to-market losses, forward oil contracts for delivery a couple of years from now are approaching attractive levels. Think about WTI in December 2027, for example. 

The problem is we haven’t seen a market yet that suggests true capitulation and thus offers great entry points. Before Trump partially reversed course on tariffs on Wednesday, the vibe was approaching that of every-trader-for-themselves. Still, at current levels, forward oil futures aren’t a risk-free bet.

At the worst point last week, the two-year forward WTI price was $58.22 a barrel; back in 2020, it traded as low as $33.75. Even ignoring the bleakest period of the pandemic, when the global economy shut down, the two-year WTI forward traded below $50 a barrel for nearly 350 days. It’s often good to review the price chart to see how low prices can go.

 

Still, a cycle doesn’t last forever. Oil tends to recover from economic downturns relatively quickly as low prices hurt supply growth and propel demand. That’s why it sees boom-and-bust cycles. “Sadly, this is familiar territory,” Houston-based oil banker Dan Pickering says. “The catalysts are always different, but the playbook is well established from the downturns of 1986, 1998, 2001, 2008, 2014 and 2020.”

What’s the argument to use the dip to buy long-dated oil futures?

1) Although 2020 taught us all a lesson of how low the market can go, the current economic instability is very different: It’s a trade war, not a crushing pandemic that froze large chunks of the global economy. Look at the debate about the impact on oil demand growth. So far, it’s about a slowdown; perhaps a small contraction, but nothing more than a 1 per cent drop at worst. Five years ago, global demand contracted by 20 per cent at the worst point.

 

2) Current prices are probably down enough to trigger a supply response as the US shale pain threshold has moved higher. On average, American shale companies say they can’t drill profitably below $65 versus $49 in 2020, according to a regular survey conducted by the Federal Reserve Bank of Dallas. Further price declines will only exacerbate the supply response.  

 

3) By approving a small output hike, Saudi Arabia is giving the OPEC+ cheaters such as Kazakhstan a spanking, but not much. In 2020, it hit Russia, which was the main cheater, with the equivalent of a first-strike nuclear attack. The OPEC+ increase is, for now, a surprise rather than a supply shock. I do caution that could change quickly — and unexpectedly. Riyadh has launched four price wars over the last 30 years (1986, 1998, 2014 and 2020). A fifth is always on the cards.

 

4) All the attention is on the Sino-American trade war, but there’s still an actual war between Russia and Ukraine, plus a volatile Middle East. The US has reimposed oil sanctions on Venezuela too. Talks with Tehran are starting, but no one knows where they might end. For several years, the winning trade on geopolitical tension and oil sanctions has been selling the rally, but past performance doesn’t guarantee future results. Maybe it would surprise some, but geopolitics still can tighten the oil market.

 

5) Trump giveth the oil-price slump by starting a foolish trade war, and Trump can taketh away. Already, the White House has shown it can blink if the bond market imposes enough pressure. If the economic pain intensifies, the president may seek a truce with Beijing. That would be the most bullish catalyst for oil prices.

 

For the past 18 months and up to the current selloff, I have been indubitably bearish. But the game is starting to change. The perma-bulls and the OPEC+ cheerleaders have thrown in their towels, which is always a good sign to take the opposite trade. Below $60, the risk-reward of being bearish is clearly different than it was when WTI traded near $100 in late 2023. But buying the dip? I like cheap but prefer everything-must-go bargains. Ask me again if we get closer to $50 a barrel. 

  (Disclaimer: This is a Bloomberg Opinion piece, and these are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper)