Here’s Why Oil Shares Are Sure To Recover

So oil is cheap now, with Brent Crude hovering around $48-49 per barrel, and the great and good of the City have been dumping oil company shares as if perpetual motion machines had been invented. But are we in a permanent state of cheap oil now, or is this just a short-term thing from which canny long-term investors can profit? I’m sure I won’t be surprising you when I plump for the latter.

The thing is, despite regular headlines telling us of a glut in oil production (led by Saudi Arabia, who urged OPEC to open the taps to try to drive prices down and kill off the looming competition from the oil shale business), the excess is actually relatively small compared to the world’s actual consumption of the stuff. But the demand for oil is seriously inelastic, and an excess of supply leading to a small drop in the price doesn’t get people to go buy more of it while it’s cheap.

Use more oil?

If the petrol price drops, do you drive the longer way to work just because you can better afford to? No, of course you don’t. And industry generally doesn’t snap up more oil products when the price drops, because factories are already consuming all the oil that’s needed to satisfy the demand for their own products — and people aren’t suddenly going to rush out and buy extra breakfast cereals, shoes, or spoons, when oil is cheaper.

So a relatively small rise in production over and above demand can lead to a disproportionately larger fall in the price, as investors have so painfully seen.

But oil prices can go up in exactly the same way, and it only takes a relatively small drop in supply. And in time, that will surely happen, because some of today’s producers are simply not profitable at the current price of crude — Saudi Arabia itself enjoys low costs of extraction, but it has little spare capacity to increase production without spending a lot of money per barrel (and it got its OPEC friends to open the sluices instead, and they might not be quite so keen on low prices in the long run). North Sea oil is especially expensive to extract, and we’ve already seen a lot of exploration work there being shelved — and there may well be more to come.

Slashing costs

Oil shale explorers are continuing to slash their costs of production and are not being driven out of business, and with a significant amount of the world’s oil being pumped up at loss-making costs, something has to give way. We will, for sure, get back to a sensible demand-driven market for oil, and that’s going to be at a higher price per barrel than today — perhaps not back to the $100-plus levels of the recent past, but I’d say at least 50% up on today’s price.

Even at $48, if you invest in oil companies that are profitable at that level, you’re surely going to do well. And that includes BP, forecast to bring in a rise in EPS this year for a P/E of only 14, dropping to 13 on 2016 forecasts. And at Royal Dutch Shell, while there’s a fall in EPS expected this year, that does give us a P/E of under 12 and predicted to dip to 11 next year as earnings increase.

Just think how cheap today’s share prices are going to look when a small drop in oil supply starts to send the price back up!

Buying solid oil companies when they're cheap could even help you achieve millionaire status by the time you you retire.

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