Over the past decade, oil markets have experienced some of the most severe conditions ever seen by one industry. The industry has been buffeted by technological change, volatile prices, rising costs, additional taxes, increasing cost of capital and the prospect of eventually becoming less price competitive than clean energy.
But against this backdrop, the outlook for the industry today is brighter than it has been for several years, even though hundreds of billions of dollars around the world are flowing into green energy projects every year and governments are pushing ahead with rules to limit emissions.
Before I continue, I should note that I do not have a position in the oil and gas sector. I think it is far too challenging to determine how this industry will look 10 years from now. That's why I am avoiding it. I think it presents an interesting case study of how value investors can make money in an incredibly cyclical industry if they have patience, a long-term perspective and a unique insight (and how they can lose money if they are lacking any of these things).
Two cycles
The global oil market has been driven by two cycles over the past decade.
First of all, the shale oil boom powered an explosion in oil production in the United States and worldwide. Cheap financing and new technologies allowed companies to ramp up oil and gas production from previously inaccessible resources.
Even though many of these companies struggled to break even thanks to the accelerated decline rate of shale oil wells and the need for continual investment to drive growth, investors shoveled money into the sector.
This all ended around 2014 to 2015. Oil prices plunged due to the supply and demand imbalance. Many shale oil companies collapsed, and investors started to avoid the sector.
Over the next few years, the industry gradually recovered. For many companies, this was an era of austerity. Big oil groups such as Royal Dutch Shell (RDS.A, Financial) (RDS.B, Financial) slashed expenses to bring down the cost of production and try and make money in an environment where the oil price would never exceed around $60 per barrel (or so they thought). There were even rumors that Shell banned free coffee from its offices.
The industry was just starting to recover in 2019 before the pandemic struck. In the first half of 2020, the sector saw something that no one ever thought would happen. The price of WTI crude dropped below zero. This sent shockwaves through the industry. When coupled with ESG concerns, many analysts had expressed their beliefs that the oil and gas sector had peaked in 2019.
As we are now seeing, that is not the case. The price of crude oil has surged to a multi-year high. Oil companies, which had slashed costs to the bone, have the potential to generate bumper profits.
Meanwhile, even though renewable energy capacity is running at full pelt, it doesn't look as if the world is installing enough green energy output to cover oil demand yet.
Difficult but not impossible
The peaks and troughs of the oil and gas industry over the past decade illustrate how difficult it is to invest in a cyclical industry. That does not mean it is impossible to make money in such an industry. For investors who know what they are talking about and can seek out the best companies with the best managers, owning cyclical stocks can be lucrative. However, this is not going to be an investment approach that is suitable for buy-and-hold investors.
Owning cyclical stocks requires continual analysis and insight into the sector. The situation in oil markets can change very quickly. Investors who don't have the right insights are likely to be overwhelmed.
Put simply, if one has a specialist insight into a cyclical sector, then one can make a lot of money. But without these insights, it is going to be almost impossible for an average investor to predict how a cyclical company will perform over a long period. Avoiding the industry altogether may be the best option.
