Oil May Be Rising But It’s Too Early To Call A Recovery

At the beginning of this month, it looked as if oil was staging a recovery. Brent crude jumped from around $48 per barrel at the end of January, to a high of $58/bbl during the first week of February.

Unfortunately, Brent then spent the second week of February falling to a low of $55/bbl, although the price of the black gold jumped yesterday morning to hit $56/bbl. 

In truth, no one really knows what the price of oil will do next. Talk of ‘mean reversion’ supply/demand fundamentals and falling rig counts, is just talk.

If anyone could accurately predict where the price of oil would be 12 months from now, with a high degree of accuracy, they wouldn’t be working as an analyst that’s for sure. They would be one of the richest people on the planet, and everyone would be following their trades. 

False rally

What’s more, even though the price of oil has rallied from its six-year low, reached during January, it’s still too early to call a recovery. Technically, if a market rallies by 20%, then it is in a bull market, which is true for oil. The price of Brent has rallied by 20% over the past month. 

However, this rally has been driven by nothing by hyperbole from oil traders, OPEC and Big Oil. Indeed, oil production around the world is still rising, volumes of oil in storage are at record levels and demand hasn’t noticeably increased. 

And it’s likely that the price of oil won’t return to $100/bbl levels until oil producers start to go out of business, taking supply out of the market. This could take some time. Many oil producers have hedged their oil production for 2015 at early-2014 prices, which should keep earnings high for the next twelve months. After that, it’s all to play for. 

What to do next

So how should investors react? Don’t try and predict the future. If you want to take a bet on the oil sector, look for companies with the best production profiles at present prices. In other words, look for the companies that are still profitable now with oil trading at present levels. That way you’re not trying to outsmart the market. A tactic that rarely works and usually costs investors a lot of money.

Moreover, as it is impossible to tell how long this downturn will last, the producers with the strongest balance sheets are the best picks. Companies like Afren, with high levels of debt and CAPEX costs, are not sensible picks.  

Additionally, as always it pays to be diversified. A basket approach is usually your best bet. 

Simply put, a basket approach uses a mixture of high-risk, high-reward stocks and trusty dividend payers, to reduce risk and help you sleep at night.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended shares in Afren. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.