Last Monday, following poor economic data out of China, both Brent crude and WTI prices dropped to six-year lows. The market, as it will, panicked and sold off.
Then, on Thursday and Friday, the two benchmarks for global and North American oil prices jumped at a faster rate than they had since 2009.
Bullish economic numbers from the United States prompted the quick rise, as investors saw the potential for more demand in North America. Again, though, this happy panic led to buying that was probably unnecessary…
You see, as I write this on Monday morning, futures for Brent crude and WTI are down already. Fears abound concerning Chinese and American demand.
Of course, the drop this morning is nowhere near as bad as it was a week ago, but it has us thinking that oil could stay in the $40 to $50 per barrel range for a little while longer unless something drastic happens.
Since we cannot predict such an event that would prompt another dramatic rise, we’ll have to be patient and invest accordingly.
And as has been true for most of the bear market, the best way to invest in energy during this slump is through the refinery sector…
Rig Counts and the Driller’s Dilemma
With oil prices low and investors waiting for them to rise, everything hinges on supply and demand.
Since last fall when the oil price rout hit hard, the supply of oil has simply outpaced the world’s demand. Add to this that Saudi Arabia cut prices per barrel to China last year, and you can see why a swift bear market took place.
Now, the story hinges upon rig counts, demand numbers, and interest rates.
After last fall’s bear market, drillers everywhere (except for Arabian OPEC members) cut capital budgets and shuttered rigs that weren’t absolutely necessary to maintain cash flow.
This worked for some time, as oil hit highs just over $60 per barrel back in June.
Then, as prices recovered, drillers started to boost rig counts, and prices collapsed again. We’re still in this phase of increasing rig counts.
Last week, U.S. rigs increased by one to 675, the highest since May and the sixth consecutive weekly increase.
As you can see in the chart above, the story of falling oil prices and last week’s volatility can be told by the rig count numbers. When companies cut budgets, rig counts fell, and prices rose; when companies started drilling more, prices crashed below $40 per barrel.
This is the driller’s dilemma: Companies can’t stop drilling altogether to boost prices because they would go under, so they have to keep drilling enough to pay for operations. These days, this has weighed on the market.
Thursday and Friday’s exuberance over the U.S. economy was a brief period of respite, as oil was headed for another recovery.
But today’s early movement shows that we are still confined to low prices and the ever-changing rig numbers.
Also important but unpredictable is the potential for an interest rate rise in the United States. An increase in interest rates by the Fed, something many have called for over the last couple years, would prop up the dollar and make oil much more expensive for foreign buyers.
Still, we have no clue if interest rates will rise this fall or if the Fed will wait given the economic slump in China and poor demand for commodities.
Instead, as I mentioned earlier, the smart investors are looking at refineries as a safe haven in the energy sector.
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Buffett Has $4.5 Billion in This Refiner
Buffett’s Berkshire Hathaway has long held a stake in Phillips 66 (NYSE: PSX), but it was announced that after purchases last week, his firm’s holdings in the company increased to 58 million shares worth $4.5 billion.
It would seem that the ultimate contrarian boosted his stake in the refiner as oil prices dropped in an attempt to both hedge against more oil price declines and see decent returns if prices come back (which they did in short order).
The reason refiners do so well during bear markets and slumps is that these companies have the advantage of being able to find more markets where they can sell their products.
You see, U.S. oil producers have to keep their oil in North America, so the only buyers to be found are in Canada, the U.S., and now to some extent, Mexico.
But refiners can export refined products as they wish, so these companies are able to refine ultra-cheap U.S. crude blends and sell the gasoline and diesel in France, China, Germany, or any other country that demands expensive fuel.
Plus, since oil prices are lower per barrel in the U.S. than in Europe and other world markets, it makes sense for refiners to export these products to take advantage of the difference.
So while oil prices may stay low for a little while longer, we should hedge our bets with refinery companies.
Good Investing,
Alex Martinelli
With an eye squarely focused on the long-term, Alex Martinelli takes the art of income investing to a higher level within the energy sector. His research has helped hundreds of thousands of individual investors identify well established companies that have a long history of paying out dividends to their shareholders. For more info on Alex, check out his editor’s page.
