Going Against the Flow Could Work Well for Oil

By McEWAN, David

Some investors work on the theory that if everybody thinks something is guaranteed to happen, then the opposite is most likely to occur. At present, everybody believes oil prices will stay high at best and, at worst, go up to record levels.

The trouble is, when everybody thinks something, their expectations quickly become priced into an asset. Therefore, the only surprise is a negative one, which inevitably causes panic and pushes prices down.

As a result, canny investors can let the laws of probability work in their favour by betting against the majority, where the potential returns are considerably higher than those gained from going with the masses.

Baron Rothschild left us with some timeless investment advice: “Buy when the cannons are booming and sell when the violins are playing.”

One should not be contrarian purely for the sake of it, of course, but there is definite merit in studying why nobody likes a particular asset that looks cheap, or loves one that seems ruinously expensive unless the absolute best-case scenario pans out.

It is refreshing to see one expert predict that the price of oil is likely to fall back to about $US35 a barrel over the next few years and push petrol back down to a little over $1 a litre. Associate Professor Anthony Owen at the University of New South Wales is reported as saying that the world has plenty of oil, and it is only a matter of time before production and refinery capacity increase to meet growing global demand.

Dr Owen believes that extreme price fluctuations in the past and a lack of information about oil reserves have undermined investment in oil production.

“Oil is a very volatile market, and lots of people have had their fingers burnt and remember it.”

He says predictions that oil supplies are running out and will soon become prohibitively expensive – the “peak oil” argument – are scare tactics.

In addition to conventional sources, there are considerable unconventional sources of oil, including oil sand and shale, which could be tapped in the future with new technologies, he says.

The price of crude oil hit a record of just above $US70 a barrel in late August, but has since been declining steadily. Bottlenecks throughout the oil cycle, including limited refinery capacity, contributed to higher prices recently.

“Crude oil price increases of 2005 largely reflect the uncertain environment and expectations of future market tightness in production capacity,” Dr Owen says. He believes oil prices will head down over the next three to five years as more supply capacity comes on line.

“I think you are going to see the oil price settle down in the mid-$US30s over the next couple of years. That’s the sort of price that will encourage investment in future production facilities.”

An unexpected downturn in the world economy would drive the price down even further, he says. “A good recession usually brings petrol prices down.”

However, alternative technologies will have to be adopted for environmental reasons in the longer term, he says. Global energy demand is expected to increase by 50 percent by 2030, increasing emissions of carbon dioxide by 52 percent.

“If oil is produced to meet demand over the next 25 to 30 years, then we are going to have dreadful environmental problems.” David McEwen is managing director of Investment Research Group. He can be reached by e-mail at david@irg.co.nz.