$50 Oil: Sustainable Or Not?

Earlier this year, oil touched $27, the lowest level in many years. But now, many analysts are reconsidering their forecasts. 6 months ago the most popular forecast was $10, now they are predicting $70 again. But how sustainable is the $50 level?

Expert Edward Morse thinks oil will rise to $61 per barrel, but it’s not going to be a smooth ride. There will be lots of volatility for four different reasons:

OPEC isn’t that dominant anymore: Saudi-Arabia forced OPEC members to stop playing police officer to keep their market share alive. They thought they could clean up the mess of overproduction. But it was a wild ride. Meanwhile Iraq and Iran joined production forces too.

Flexible shale production: The low oil prices forced lots of shale companies to shut down their wells. But now the oil prices almost doubled, they can be put online again in no time. Shale production is very flexible.

Political instability: There is lots of instability in big oil countries, think Libya, Iraq, Nigeria and Venezuela. The low oil prices caused a lot of social trouble in these countries.

Wall Street: The biggest cause for high volatility is Wall Street. HFT and robot trading causes big and unsuspected moves. How else can you explain the move from $26 to $34 in just 2 weeks?

Now should you sell the rally …

Deutsche Bank thinks this is the best time to sell oil stocks. The US energy sector is now trading at a roughly 7x EBITDA multiple compared to a historical average between 1x and 2x. But more than just equities, the risk of a sharp repricing is just as evident in the junk bond space, where energy is by far the largest sector amounting to just shy of 16% of all outstanding issues.

Many investors think the higher oil price will lead to a better valuation. But besides the toxic cocktail from a high valuation and a high default rate, there is another aspect to take into account: The Federal Reserve. When the FED hikes again, the USD will get stronger and the price of oil will probably decline.

… or is it still a buying opportunity?

Jeffrey Taylor from the Invesco Euro Equity Fund still thinks it’s time to buy. He thinks there is a new balance between supply and demand. Big oil companies were sold off too much and are still cheap relative to their balance sheets.

Investors are paying too much for blue chips and are ignoring the undervaluation for oil companies. He also thinks demand will pick up in Europe. The reality isn’t that bad compared to expectations.