The oil price has collapsed. So is now a good time to invest in oil giants? Their prices look right. Shares in BP are down by almost 40% from their year peak. Royal Dutch Shell shares are down by around a third.
Should the oil price recover, I would expect shares in BP and Royal Dutch Shell to recover too. But there’s a catch. I only expect this recovery to be short-lived and to be volatile long into the future.
Oil price, what next?
Predicting what the oil price will do in the short run is a mug’s game. But I do think that in the medium term, let’s say over the next half a decade, the price will go up. Yet longer term, I have my doubts.
The oil cycle moves slowly. When the oil price is high, we gradually change habits. As our car ages, we may replace it with a more fuel-efficient model. Simultaneously, we may insulate our loft or buy solar panels. Industry will change habits too, but slowly. As for oil supply, under these conditions, the oil industry typically invests more in exploration.
Human nature being what it is, a narrative then emerges that the elevated levels of that period will become permanent. However, as a consequence of the slow changes I described above, eventually oil supply rises just as oil demand falls. The price then crashes.
When oil is cheap, we see the reverse conditions occurring, gradual changes in demand and supply happen, until the oil price increases.
These slow-moving changes in demand and supply is why we have an oil market cycle.
Once the Covid-19 crisis finally ends, there will still be a massive oil inventory. I expect the economy to recover slowly, but eventually, demand for oil will rise and the oil inventory will disappear.
For that reason I expect the oil price to surge again later this decade. In theory, shares in oil companies will recover at that point, perhaps a little before.
The end of the cycle
I also suspect that cheap oil will slow the advance of renewable energies and electric vehicles. But I don’t expect this to be significant. The economics of electric vehicles are becoming ever more compelling, not least because they have fewer moving parts and can be cheaper to maintain. The cost per unit of energy of renewables is constantly falling, as is energy storage costs.
And let’s not forget the one extremely important factor missing from the above narrative — climate change.
Just as the world has reacted to the threat posed by Covid-19 with a lockdown, irrespective of the economic costs, I suspect that in the second half of this decade, when the reality of the true costs of climate change finally sink in, we will rapidly move away from oil, and adopt alternatives regardless of the costs.
Fortunately, by then I expect the cost of energy generated by renewables to be so cheap that the economic damage caused by a switch away from oil will be modest.
Oil companies will be hit hard by this move away from their core product. I still think the oil giants looks interesting as they’re investing in oil alternatives. But I’d need to see more proof of how these investments will boost their businesses before I buy.
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Michael Baxter has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.