The oil bottom

The rapid decline of oil prices have dominated the financial news the second half of 2015. Each time you turn on CNBC chances are a Wall Street analyst is discussing the latest movement in oil prices. Just the other day one proclaimed "I believe we hit the bottom!".

The price of oil has fallen from $110 per barrel in 2014 to $35 at the end of 2015. The reason for this massive drop boils down to the economics of supply and demand. On the supply side, the world produces more and more oil. The United States and Canada keep raising production year after year. The Organization of the Petroleum Exporting Countries (OPEC), a cartel of oil producers including Saudi Arabia, Iraq, the United Arab Emirates and other gulf allies, recently agreed to increase the production of oil because they don't want to lose marketshare and because they know it drives the U.S. shale oil producers out of the market. Last, but not least, Iran is about to re-enter the world of oil markets in 2016 after years of sanctions and isolation. On the demand side, we see that demand for fuel is lagging a bit, resulting in an overproduction of oil.

When there is more supply than demand and no one is cutting production, the price of oil will keep dropping, and eventually the world might run out of places to store all the excess oil. Many oil producer are struggling to maintain their profitability and incurring losses.

I'm not an expert on the oil industry, and I certainly understand that it is impossible to predict the future, but to me it seems the worst is yet to come. As I see it, there are four scenarios that could play out: (1) oil producers agree to balance supply and demand by cutting production, (2) the demand for oil picks up as the world's economies strengthen, (3) the supply of oil starts to slow down as oil producers can't afford the investments to sustain production, or (4) enough oil producers go out business and supply and demand is rebalanced that way.

I don't have a crystal ball, but I consider a combination of (3) and (4) to be the most likely outcome. Oil production companies have been slashing their capital budgets throughout 2015 to stay in business. Multibillion-dollar explorations and production projects have been delayed or cancelled. This should cause oil production to drop naturally in the future. To weather the storm, cutting capital budgets might not be enough; oil companies might have to increase their debt levels, and those that can't raise more debt might have to dig deeper and cut their dividend. I wouldn't be surprised if we saw various oil producers cut their dividends in the second half of 2016, and witnessed a series of bankruptcies or acquisitions in 2017.

Because of the drop in oil price, many of the oil companies have become unusually cheap, often trading at 10 year lows. For people with a 5-10 year time horizon, it is probably a great time to buy stock in one or more integrated oil and gas super majors, especially if you stick with the few that are still able to support their dividend. At the same time, I believe the worst is yet to come. As someone investing part of his paycheck for retirement, I'll sit on the sideline a bit longer until the above scenario starts to play out. In the mean time, I'll keep wondering and learning why Wall Street analysts keep calling the oil bottom ...

Disclaimer: I'm long XOM with a cost basis of $68 per share, and would probably add to my position if XOM hits $70 per share again. Before making an investments, you should do your own proper due diligence. Any material in this article should be considered general information, and not a formal investment recommendation.