The cheapest bet on rising oil prices

Yesterday, the price of oil rose to levels not seen since 2014, which was when the most recent oil price crash really got going.

Brent crude rose to above $73 a barrel, while the US benchmark – West Texas Intermediate – climbed above $68.

Can it last? And what’s the best way to profit if so?

The oil market recovers its winning streak

Back in 2014, oil prices crashed as the market finally accepted that US shale oil was here to stay. Oil cartel Opec decided to adopt a strategy of maintaining production levels, with the goal of wiping out the shale industry, by driving prices down to levels where production could no longer be maintained.

However, that didn’t happen. The availability of very cheap financing combined with rapidly improving technology was enough to allow the shale producers to cling on for much longer than Saudi Arabia and its partners had anticipated.

Instead, it was Opec who gave up first. Oil prices hit rock bottom in early 2016, then started to bounce along with the rest of the commodity sector.

Then in late 2016, with prices around $45-$50, the cartel agreed to cut oil production. However, it wasn’t until mid-2017 that oil prices really got into their stride, and since then, they haven’t really looked back.

If you look in the news, then there are any number of reasons for the latest mini-surge in prices. Firstly, US crude oil and petrol stockpiles fell by more than expected last week, according to the US Energy Information Administration.

The market was also buoyed up by rumours that Saudi Arabia is keen to maintain reduced production levels. In fact, Opec is meeting in Jeddah tomorrow, and according to “industry sources” (as newswire Reuters put it), “Saudi Arabia would be happy for crude to rise to $80 or even $100”.

Why would Saudi Arabia want that? Primarily because it happens to have an absolutely massive state-owned oil company to sell (well, to sell a tiny bit of), and so it wants to prepare the market to fetch the best price it can possibly get for it.

The oil giant, Saudi Aramco, is the piggy bank that the Saudis are planning to smash (or at least shake a few pennies out of) in order to fund the ambitious (perhaps even grandiose) plans of its current leader, Mohammed bin Salman.

And as always, you can throw in a bit of Middle Eastern instability for good measure. Syria doesn’t matter much to the oil price, but if problems spread, or the US decides it’s time to re-introduce the sanctions on Iran that were only recently lifted, then that would disrupt supply.

Right now, the market is bullish on oil, so let’s assume it’ll continue

There’s always a reason for the oil price to go up when it’s rising. Just as there’s always a reason for it to go down when it’s falling.

But as far as I can see, oil is one of those economic variables that you are better off reacting to rather than trying to predict. It’s very much a market where the news follows the price – in other words, the story gets told according to what the price does, rather than the other way around. (Most markets are like this but I’d say that oil is one that it’s particularly pronounced in.)

For a start, people go on about the power of Opec. But it’s a mistake to over-exaggerate its influence. Production cuts might bolster sentiment, it’s true, but the reality is that oil prices bounced at the start of 2016 because they had fallen so dramatically and sentiment had soured so much. The production cuts kicked in much later (and the oil price fell for about six months afterwards).

So don’t fall for the idea that the Saudis want oil to be at $100 a barrel, and therefore it will get there. That’s not how it works. Bear in mind that the pre-2014 consensus (and I mean consensus, as in every oil fund manager I spoke to firmly believed it) was that Opec would not tolerate prices below $100 a barrel. And clearly, that turned out to be nonsense.

So the fact that Saudi Arabia has to sell Aramco is not a good reason in itself to be betting on a higher oil price.

There’s also the fact that the US dollar has slid precipitously in the last couple of years (oil, of course, is priced in dollars, so, all else being equal, a falling dollar means higher oil prices). So the direction of the dollar has a big impact on prices too.

However, if you asked me to take a punt, then I’d say that oil is probably set to head higher or stay around these levels. One way or another, the reality is that the psychology on oil right now is bullish and people are looking for reasons to buy. The trend has clearly changed. And there’s also no particularly compelling reason to imagine that oil prices should crash.

Production may increase, but the shale producers aren’t stupid either, and the big oil companies have all been burned by the last crash, so they’re not keen to return to the days of over-investment and chasing marginal wells.

Who’ll be a winner if oil prices remain high?

So let’s assume that oil continues its winning streak. What might that mean? Higher oil prices are increasingly priced into most of the relevant markets, I feel – energy stocks aren’t expensive by any means, but they aren’t as cheap as they were.

But if you are interested in investing in Russia, then it’s probably the cheapest oil-dependent play around right now (indeed, unless you can find a small-cap firm that has fallen on hard times and is just around the corner from a massive oil strike, Russia is almost certainly the cheapest play on oil right now).

Merryn and I talked about Russia in the latest MoneyWeek podcast, and you can listen to our debate here. I’m still not keen to invest there, but you could argue that I’m going against my own logic of investing when markets are cheap (and you would almost certainly be right).

So if you’re looking for a cheap play on oil (even at prices that are lower than today’s), then Russia’s probably the best bet.

The other interesting thing to consider is the potential effect that the oil price would have on inflation. Inflation appears to have come off the boil for the moment – in the UK, for example, inflation in March came in a lot lower than anyone expected (the consumer price index is rising at an annual rate of 2.5% now, from 2.7% a month ago).

However, it’s worth remembering that sterling is a lot stronger than it was this time last year. And if oil prices keep rising, they will have an impact on headline inflation.

Meanwhile, if wages strengthen too, as appears to be likely – particularly with record-low unemployment levels – then it’s quite possible that at some point later in the year we’ll get an inflation reading that surprises on the upside rather than the downside.

Anyway, it’s something to keep an eye on.