The golden opportunity for "black gold" (yet?)

It is now impossible to pass a day without hearing news on oil price. WTI crude has declined from the top at $106 in July 2014 to today's $28 (2016.01.21), a whopper 73.6% decline. It lost 25% already this year. Is this the darkness before dawn, the acceleration to the bottom before the rebound? While the fear of deflation pervades media headlines, some investors have been watching closely for an entry.

Quote trader Jared Dillian: the bearish argument always sound most compelling on the lows.

So I'd say it is time to pay attention.

I propose to approach the topic with three questions in order: when, whether and how.

When is the bottom? - i.e. how low can it go

Theoretically, the producers should be able to make a profit as long as the price is above the marginal cost of production. These costs vary considerably between producers, but also depend on whether the focus is on the short-run costs of operating an existing well, or the long-term costs which also include the capital expenditure required to renew and expand output. In principle, firms will continue pumping oil as long as the selling price is above the short-run (or cash) cost. However, new investment will evaporate if prices are expected to be less than the long-run (breakeven) cost.

Source: various, Capital Economics (It is worth to be mindful that there is widespread uncertainty about these numbers, so we would take these as indicative rather than definitive.)

The current price of around $30 is still some way above the short-run costs of production of key Middle East suppliers and the US. This is the basis on which it makes sense to talk of further price falls.

Some commentators have concluded that prices could drop below $10, which would still be above the lowest costs in Saudi Arabia. I think we need to be skeptical about this call because it would be impossible for Saudi Arabia to supply the whole world. Instead, it makes more sense to focus on the US, which is probably now the marginal producer and where supply cuts are likely to accelerate if prices drop below $25. Hence, production and stock data from the US are the most closely-watched.

Will the price recover, or will it stay low in the long run?

In short term, market can overshoot. $20pb is plausible. However, the important point is it is unlikely to stay at this level. It is noted that prices have already fallen to levels which are choking off new investment both in the US and around the world. Indeed, the further that prices fall in the near term, the bigger the supply cuts are likely to be, and hence the stronger the rebound in prices as shorts scramble to cover their positions.

In medium to long term, the new equilibrium price is largely determined on the supply and demand. At $30 pb, producers can not maintain capex in the long run. US shale gas drilling has already collapsed along oil price.

Source: Thomson Reuters

On the demand side, the wild factor is China and other developing countries, as well as the threat of replacement of oil by new fuels. The recent China sell off has spooked the market as well as putting pressure on oil price. However, although 2016 will be another year-in-transition for China for its financial market reform, currency setting and geopolitical challenge, I do not expect a hard landing. The lower than expected GDP number earlier this week is worth a closer look under the surface. Bit more on that in a later post.

As to new fuels, it will be adopted in developing nations faster than in developed countries. However, I suspect the world is still heavily reliant on oil until we reach that tipping point. I am not saying oil is going back to $100 pb in a hurry. However, seeing it back at $40-50 range is a rather plausible scenario.

How do we take advantage of this opportunity?

1. Long oil producer's stock - this is the most straight forward way.

Pro: simple and straight forward. Relatively cheaper to execute.

Con: could have significant downside risk if the price drops further; no leverage (the margin lending option is not recommended until some capital gain is achieved). Significant upfront capital required.

2. Hedged Loan - this involves buying stock on margin loan and buying a put option to protect the downside.

Pro: relatively simple, allows for leverage. Depending on eventuation of the foretasted dividends and franking, the cashflow from the loan and option could be compensated (at least to an extend).

Con: Put options are extremely expensive due to heightened volatility. This will deteriorate the cashflow situation. Upfront capital still required to pay for the equity and puts.

3. Bull Put spread + call: this is the recommended strategy.

Pro: Significant leverage with limited risk. Downside is limited to the gap between the puts, net off the premium received, plus the call premium. However, a long dated call option with expiry before a dividend date is recommended. Upfront cashflow positive.

Con: Still with limited downside risk. More complex structure.

Note: This strategy requires investor to be comfortable with using options.