With the recent decline in the price of oil, many investors are wondering, where the opportunity is to make money from the decline? As I have stated before, my investing motto is always to keep it simple; which in this case would mean "simply buy oil stocks."
Over the past few months, the price of oil has unexpectedly fallen from over $100 a barrel to the $50 range. Neither economist, market analysts, or oil industry experts saw this decline coming. So I believe it is safe to say that no one, certainly including myself, knows were the price of oil is going in the near future. But with that being said, I think most would agree the use of oil is not going away in the near future. Oil is and will be the most widely used form of energy in the coming years, despite the rise of natural gas, solar or any other form of energy which currently exists.
The fall in the price of oil has caused oil stocks to decline. For example, Exxon Mobile (XOM) is down more than 8% over the past six months while Chevron (CVX) is off by nearly 14%. Smaller players like Anadarko Petroleum (APC) is off by nearly 22% and Pioneer Natural Resources (PXD) is off by 32% as the price of oil has fallen during the second half of the year. These types of declines have been felt throughout the industry.
One of the first and most common antidotes we are taught as investors is "buy low, sell high." When stocks fall, their price is low or at least lower than it was, which means if you believe in the company, or in this case the industry, then now is the time to buy.
Who to Buy
With so much uncertainty about where the price of oil will be in the future, it is difficult to accurately predict which companies will be able to ride out the lower prices. While it is safe to believe that the bigger players such as Exxon and Chevron will be able to withstand low oil prices better than smaller industry players, those companies may not give investors the most bang for their buck. Over the past five years, Exxon is up 38%, which any investor would likely be happy with. On the flip side though, a smaller oil producer such as Pioneer, who may not be able to withstand low oil prices for an extended period of time, is up 217% over the same time frame and is the best performing energy stock in the S&P 500 since 2009.
So how do you know which oil company to pick moving forward? Start by digging into the 10-k's of each company in the industry. Try to figure out what it cost each company to produce a barrel and see at what price level the company is no longer profitable. This will be a time consuming and very tedious process. In most cases, the lost cost producers are going to be the lower growth companies, meaning if the price of oil climbs, your returns will be lower than others due to the lower risk. So in order to get higher returns, you will need to go with the higher cost producers, which leads to a higher amount of risk taking since they could go belly up if oil stays low for a long time.
Clearly the classic risk-reward antidote is at play if you're thinking about cherry picking energy stocks right now. Luckily though, there is another option. Buying an oil ETF will allow you to play the recent decline in oil stocks without taking on more risk than you need to while still providing adequate return if the price of oil rises in the future. ETFs such as the Energy Select Sector SPDR Fund (XLE) or the Vanguard Energy ETF (VDE) will provide both lower risk than buying small oil stocks in case the price of oil continues to fall and higher reward than buying the large oil stocks if the price of oil moves higher.
When to Buy
Once you have decided which ETF to purchase, the only question that remains is "when to buy." Since we don't know where oil is heading, the fear is that if you buy today, you may be trying to catch a falling knife. While that may be true, I would suggest buying in thirds over the next six months.
If you have $9,000 to put into the oil sector ETF, buy $3,000 worth today, another $3,000 in three months from now, and the final $3,000 in six months' time. This way you are averaging your cost basis over a longer period of time, thus protecting yourself from any future declines in the price of oil.
One of my favorite Warren Buffett quotes is, "be fearful when others are greedy and greedy when others are fearful." I believe this quote perfectly sums up how investors should be thinking about the oil industry today. Fear has caused oil stocks to fall, which has led to opportunities for those looking.
INO.com Contributor - ETFs
Disclosure: This contributor has no positions in any stocks mentioned in this article. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.