Geopolitical events are once again roiling the oil market, causing the fear factor to push the price of the commodity higher and leading commentators to trip over each other as they jockey to predict soaring oil prices over the next few years. (For related reading, also take a look at What Determines Oil Prices?)
TUTORIAL: Economic Indicators To Know
While some investors may be tempted to jump in and invest directly in the volatile oil market, the sands can shift quickly in a market dominated by short-term investors. Here are seven reasons why you might want to stay away.
1. Supply Response
The escalating investment in oil exploration and development will eventually provoke an excess of supply to hit the market. It's hard to predict when this will occur, but in our hearts we all know this will happen eventually. The talking heads on television seem confident that supply will never be enough to meet the insatiable demand from the emerging economies, but remember these were the same smart guys who told you five years ago that natural gas production in the United States would never increase enough to make a difference. Ten years ago they were telling you that no amount of bandwidth was enough to meet demand.
Momentum is playing a large role in the recent increase in oil prices as strong price gains generates more headlines and draw even more investors into the game. While it might be fun to watch the price of oil move higher due to a technical breakout, the nomenclature used here implies a lack of fundamental support behind the move. Unfortunately, this momentum can cut both ways and oil can drop in price just as quickly as it moved up.
3. Too Much Capital
Capital is flooding into companies engaged in oil exploration and development as the frenzy of investor interest builds to a crescendo. There has been a capital frenzy in other industries over the last decade and that these episodes often end badly for most investors. While some dreamers would like to believe that the capital markets are efficient at allocating funds, this function is imperfect and usually falls short.
Buying oil and other commodities is the consensus point of view among many investors, both institutional and retail, and experience indicates that the consensus viewpoint is typically the incorrect one. This consensus is usually reinforced by groupthink, social proof, confirmation bias and a host of other behavioral issues that operate just below most investor's consciousness.
5. High Expectations
Investors have high expectations on the returns that they will generate from oil and other commodities. A recent survey conducted by Barclays Capital indicates that 28% of investors expect annual returns over the next five years to exceed 10% each year. Another 60% of investors are looking for returns between 6% and 10%. Will such high expectations inevitably lead to disappointment and a rush for the exit?
A frequent charge by some pundits is that the price of oil is manipulated by speculators and other large financial players in the market. Although there is scant evidence that would be admissible in court to prove this allegation, gut instinct tells many investors that there is probably some validity to this claim.
A quick review of the financial history of the United States and other countries reveals many instances of the manipulation of commodities, stocks and other financial instruments at various times over the last few centuries. While regulation and government oversight is much improved over the years, so is the cleverness and technology available to traders in this market.
7. Weak Investment Thesis
The investment thesis that supports the oil and commodities boom is that the growth in demand from China and other emerging economies will keep prices moving higher as operators struggle to generate the extra supply needed. This thesis is fragile and rather simplistic, which is probably why it is so often repeated in the media.
My experience as an investor is that when you take a current growth rate and project it far into the future and build an investment case on that basis, something horrific will usually occur. This same logic has been appended to the growth of the internet, personal computers, bandwidth and many other areas, only to later have this growth implode.
The Bottom Line
One interesting part of the Barclays Capital survey was the question that asked what the main concerns are of institutions that invest in oil and commodities. Over 50% cited "China risks" or "price bubbles" as the primary worry, perhaps implying that many of them do not have a firm belief in the fundamental story that supports oil prices.
Although oil investing appears exciting to many who watch in envy as others get rich, it may be a dangerous place to stay in the long term. (For additional reading, also take a look at 4 Benefits Of Rising Oil Prices.)
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