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Falling Oil Prices Create Questions for Investors

If a knife falls, should you try to catch it?

This seems to be the reverberating question around falling oil prices. With the rate of Brent crude (the global benchmark) around $35 per barrel, well short of its $110 high 18 months ago, it would seem an opportune time to start investing in the black gold. But as investors have seen time and again, there’s no guarantee that the downward trend has abated. To be sure, before slumping to its current price, oil trended around $50 followed by $40, both times disappointing the advocates who called bottoms.

With daily worldwide consumption averaging 93 million barrels (~3.9 billion gallons) in 2015, oil’s demand is obvious. A whopping 70% goes toward transportation. But before automobiles and aircraft can burn gasoline and jet fuel, they must first be derived from crude oil.

After being pumped from the ground by an exploration and production company, crude (or raw) oil has little use. It must then be transported hundreds or thousands of miles, often by pipeline or rail, to a refinery, where the oil is converted into many products such as diesel, heating oil, gasoline and jet fuel.

But if demand is so prevalent, why has oil’s price fallen 70% during the previous 18 months?

Simply put, there’s too much of it. As oil supplies surged in the last several years, partly due to cheaper and more efficient extraction methods, a glut was created. Couple this with slowing global growth, particularly in China, and the sharp price decline is not surprising.

For consumers, the benefit of low oil prices has been gas pump savings. The average American driver saved $540 in 2015. Many even traded their sedans for large gas guzzlers.

But these consumer tailwinds came at an expense. Oil exploration companies have found it difficult to break even, let alone turn a profit. Many took on expansion debt during the last few years when oil was fetching top dollar. Now, these firms are forced to keep their spigots open to service these payments, further enhancing the glut.

Countries with oil economies, such as Russia, Saudi Arabia and Venezuela, have also taken a significant hit. Because they rely on income from their sovereign oil firms, their ability to fund government activities has dwindled. In fact, Saudi Arabia is considering selling a stake in its prized, state-owned oil business, Saudi Arabian Oil Company, to raise domestic reserves.

These events have caused many to speculate on a long-awaited reversal from the Organization for the Petroleum Exporting Countries (OPEC). Though this 13-nation cartel was formed to stabilize oil markets and ensure profits, worldwide results suggest otherwise. A large reason for OPEC’s decision to stand pat was so members could maintain their respective market shares. If they reduced the amount of salable oil to decrease stockpiles, who’s to say a competitor wouldn’t replace them?

Of course, OPEC is now giving more thought to stepping in, especially as Iran, a large member, eases out of U.N. sanctions and rebuilds market share—furthering the oversupply.

With daily global surpluses forecasted at 1 million barrels for 2016, the practical solution is to shrink production. Oil prices won’t recover until stockpiles shrink. (In fact, finding affordable oil storage space is becoming an issue.) And as highly-indebted oil firms continue to file for bankruptcy, the resulting lowered competition should help. Moreover, the industry has yet to witness a wave of industry consolidation, especially deals shepherded by the oil supermajors (Exxon Mobile, Chevron, Royal Dutch Shell and BP), which should reduce production.

Yet plans to reduce the glut could be countered by growing efforts to fight climate change with renewable energy such as solar, wind and hydropower. In fact, 195 countries signed the Paris Agreement last December with the intention of reducing carbon emissions. Nevertheless, fighting climate change does not imply abandoning oil usage—most likely, it will spur more efficient use of it.

So, does the falling knife still look tempting?

Though the world is still drowning in cheap oil, only time will tell if the situation continues. Any plan to invest in oil should be rooted in fundamentals. As Warren Buffett asserts, “Price is what you pay; value is what you get.” If an analysis concludes that value exceeds price, catching today’s falling knife may result in striking black gold in the years to come.

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