Oil is at it again. After a nice rally to over $50 a share, we are back below $40. Several months ago, there was no shortage of oil executives and experts calling for an oil recovery in the second half of 2016. Several months ago, there was no shortage of oil executives and experts calling for oil prices to head lower and stay lower. What is an investor to do?
Well, first things first. The experts who may seem right today with their predictions are not smarter than those who look wrong today. In fact, whenever you have a tails vs. heads type of probability, getting one flip of a coin right is simply luck.
That being said, those interested in investing in oil are best suited to completely and utterly avoid following any forecast. Indeed, the future direction of oil prices plays a big factor in the future value of oil stocks. But you should not be purely investing in oil, or any commodity for that matter, based on your guess of future prices. I believe you can begin by making some rational assumptions, the first being that at a certain price the cost of producing oil becomes greater than the cost of selling it. At that point, supply will inevitably decline as businesses will not continue selling at a loss.
With that foundation, you also must heed John Maynard Keynes, who observed that the market can stay irrational longer than you can stay solvent. In other words, since no business wants to shut down, oil companies will do whatever they can to stay in business. Some will borrow more money to keep production going; others will find ways to produce more with less.
The efficiency gains, especially in natural gas, are probably the most underestimated occurrence today in the U.S. Over the past several years, energy companies, especially the smaller players like Sanchez Energy (SN) and Comstock Resources (CRK) along with giants like Chesapeake (CHK) are producing a lot more product while significantly curtailing capital spending.
Over time, the market self-cleanses. Higher-cost producers lose out to lower-cost producers. Leveraged companies succumb to the burdens of debt.
So the way to invest in energy is quite simple. First, you want to find the lower-cost producers. Pioneer Natural Resources (PXD) , along with the other names mentioned here. Not only are these businesses becoming more efficient, they also possess strong management teams, an incredibly huge advantage. You also want a manageable balance sheet. Chesapeake and Comstock are dealing with tough debt issues, but you can also see how quality management can make a difference.
Finally, and most importantly, because no one can predict the future, you have to invest with a very long-term mindset. At a minimum, you have to be looking to 2018 or beyond to see the real potential of investing in energy.
If you can do all these things, without fail, investing in oil is likely to be a very lucrative investment opportunity. A businesslike mentality is absolutely required.
