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Can Arab nations balance their budgets?
May 13, 2016

At Equitymaster, interacting with our subscribers is integral to our business and services. Their queries and feedback keep us on our toes and encourage us to do better every day. Further, they help us understand the dilemmas and psychology of a retail investor.

I recently got a letter from a subscriber about 'the dilemma of oil investment'. He wanted to know if it makes sense to bet on better oil to capitalize on the crisis. I'm sure he's not the only one. With a commodity as slippery as oil, it's difficult to formulate an investing discipline, let alone stick to one.

Now, if you're looking for me to tell you where oil prices will go in the near term, you should quit reading now. This is for serious investors looking for long-term investment ideas.

So here are my views.

Crude reserves are the sense that the time it takes to create a barrel is a humungous multiple of the time it takes to consume one. So as the burn rate continues to outpace supply, the value of oil should go up.

Further, holding other factors constant, as the world drills more oil, the marginal cost of oil production will go up as the ageing fields will need better techniques for oil to be extracted.

And with shale production slowing and oil exploration companies cutting capex, new discoveries will take a hit, further strengthening the case for eventual price increases.

Also keep in mind that, as much as we hear about alternate sources of energy, none of them is going to replace oil in the foreseeable future.

For now, prices are following demand-supply dynamics. They are down on a rise in OPEC supply and are already factoring in a demand slowdown. But this supply equation itself is quite unstable and unlikely to continue forever.

You see, the oil glut is a result of a clash between two titans battling for supremacy - OPEC led by Saudi Arabia and non-OPEC led by the US (with its shale revolution).

The oversupply by OPEC has brought shale producers to their knees. High-cost producers with huge debt on their balance sheets are getting squeezed out of the market. Oil companies in the US are going bankrupt and are on the verge of closure. Shale projects are lying idle.

Seeing all this carnage, we wonder if new projects will be undertaken and if anyone will be willing to fund capital-intensive shale production even when oil prices rise.

The US might be first to blink... But it's turning out to be a pyrrhic victory for OPEC. Crude prices have fallen to decade lows. While the cost of production for economies like Saudi Arabia is much lower, these economies survive and thrive only on oil.

So with oil prices in a downward spiral, these economies have suffered the most. Huge surpluses are swinging into deficits. While the fiscal buffers (thanks to high oil price era) can offer comfort for now, it won't last long.

As per the IMF (International Monetary Fund), most countries in the Middle East (which are largely responsible for the oil glut), including Saudi Arabia, will run out of cash within five years if oil stays below US$50 per barrel.

The chart below shows the price of oil required to balance the budget of these countries.

Logically, oil prices must go up.

Warren Buffett boosted his bet on the oil industry by investing in two companies as oil touched 12-year lows. And this seems to be well timed. If short-term prices are any indicator, it has already taken a turn. Brent crude is up 69% since the decade lows in January 2016.

Now, if you haven't invested, it's not a lost opportunity yet. If global extraction costs are any indicator, oil prices are still much lower than where they should be. And while I cannot give a timeline as to when they will reach reasonable levels...when they do, oil exploration companies with strong balance sheets and crashed-market valuations could offer multibagger returns.

For retail investors who have the patience to practice value investing, the Stock Select team already has one such opportunity in their buy list. Its 3% dividend is a cherry on top. The team has recommended a lot of other commodity-based stocks that seem unreasonably beaten down.

So how to capitalize on the opportunities in oil? It's not just stable and attractively priced oil producing companies that you can bet on. The oil-led crisis for Middle East economies has beaten down stocks of other businesses that have exposure to these economies (via exports). An example being our Hidden Treasure recommendation from November 2014.

The stock has corrected 27% since our recommendation on overblown concerns. We believe it offers a great opportunity for investors at current levels.

Mind you, just betting on an oil price reversal is not enough to earn returns. You can't afford to ignore the bottom-up approach. Invest only in companies with balance sheets that can withstand the oil price crisis if the situation doesn't turn around in the near to medium term.

Do you see opportunity in the oil crisis?

Source : IMF,
*To balance budget

This Chart Of The Day was published in The 5 Minute WrapUp - This Could Be the Biggest Buying Opportunity Out There

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