It was a delight for motorists while it lasted. For a week or two, gas stations in my neighborhood were charging as little as $1.93 a gallon for regular unleaded.
Then, seemingly in the blink of an eye, prices popped back above $2, where they’ve stayed. Crude oil, after a waterfall decline in December and January, has bounced more than 15%.
What’s going on here? It has nothing to do with a conspiracy by Big Oil or the greed of Arab sheikhs. It’s the law of supply and demand in action.
According to experts, the global cost of finding and lifting a marginal barrel of oil is somewhere around $80 a barrel. Otherwise put, $80 is where the price would settle over the long term if supply and demand balanced each other out.
When crude broke decisively below that level in November, the first reaction of some producers was to step up output in the hope of maintaining their revenue stream. Within weeks, however, banks and other lenders began pressuring oil executives to scrap high-cost drilling projects.
According to Baker Hughes, the North American rig count has already plunged nearly 30% from its September 2014 peak.
It may well take a few more months before a declining rig count forces U.S. and Canadian oil production to flatten out. Thus, I can’t rule out the possibility that West Texas light crude may test — or even briefly undercut — its January low around $44 a barrel.
However, it’s clear that the free market is doing what it’s supposed to do. Low prices have set in motion the process for curtailing supply. Higher prices will result, ultimately approaching the marginal price ($80) and then exceeding it.
Big Dividends in Oil
The key here, as in so much of investing, is the timing. My base case calls for Texas tea to work its way erratically higher into the summer, to perhaps the $65–$75 zone. (The August futures contract is already changing hands around $56 per barrel.) In that scenario, the U.S. oil industry would still experience a serious contraction, but the strongest players would easily survive.
Ideally, the international integrated oil majors I’ve recommended — BP plc (ADR) (NYSE:BP), Chevron Corporation (NYSE:CVX), Exxon Mobil Corporation (NYSE:XOM) and Royal Dutch Shell pld (ADR) (NYSE:RDS.A) — would all continue to dole out their dividends at the current rate. As we speak, all but BP are trading within reasonable buy limits. However, the best value appears to be Royal Dutch Shell, with its juicy 5.5% yield.
Elsewhere in the energy sector, Canada’s Pembina Pipeline Corp (NYSE:PBA) continues to look attractive for its secure 4.4% dividend, paid monthly. This toll-taker business may feel some impact this year from slower growth in western Canada’s oil and gas shipments. As the oil price snaps back closer to its equilibrium level in 2016 and beyond, though, volume passing through Pembina’s system will ramp up nicely.
Play Oil With Banks
In addition to energy stocks per se, certain banks will benefit from a recovery in oil prices. If you’re of a speculative mindset, you might take a flyer in banks that lend heavily to the oilpatch, such as certain regional institutions based in Texas, Colorado and North Dakota.
However, I feel more comfortable with large banks in Britain and Canada, two countries with significant but not overwhelming exposure to the energy business. In past issues, I’ve already detailed my case for London-based HSBC Holdings plc (ADR) (NYSE:HSBC), the world’s second-largest bank. It’s a well-capitalized institution that pays a handsome 5.6% dividend in U.S. dollars, free of withholding tax.
What about HSBC’s downbeat Q4 earnings report? Obviously, I would have hoped for a better result. However, HSBC managed to boost its year-end dividend, bringing the total payout for the year to $2.50 per share (versus $2.45 a year ago). In the long term, HSBC’s growth prospects still look bright.
If the price dips a few points, you might also pick up a few shares of Canada’s Toronto-Dominion Bank (NYSE:TD). Nearly half of TD’s deposits originate in the U.S., where TD operates an extensive branch system up and down the east coast. (Toronto-Dominion also owns more than 40% of TD Ameritrade, the stock brokerage.)
Thus, there’s little reason to think of TD as an “energy bank.” Yet, the share price has backtracked sharply since last summer, in sympathy with oil. The current yield of Toronto-Dominion Bank is 3.5%.
Two Risks to Keep an Eye On
Even though my baseline scenario calls for a gradual rise in oil prices, I recognize that events could take a different turn. If crude were to crash again, to $30 or even $20 as some grizzly bears have predicted, we would have to consider hedging our portfolios against a deflationary accident (recession).
On the other hand, a steep rebound to $80 or $90 by mid-year — though now seemingly a remote likelihood — might embolden the Federal Reserve to raise interest rates faster than most observers expect. Rapidly rising rates would carry their own set of dangers for the economy and stock market.
I’m not betting on either of these extreme outcomes. However, I’m not so foolish as to rule them out. Proceed as if they aren’t going to happen, but be prepared to shift your ground if the evidence changes.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.