Oil Is Cheap But It Isn’t (Yet) a Bargain

Back in May 2020, the head of a top commodity trading house said he had been placing large orders for oil futures without looking at his screen for the latest price. "Please, don't ever quote me saying that," he told me. "I would look like a fool." The executive wasn't one, though.

At that point during the pandemic, oil prices had declined so much that forward contracts for delivery two, three or five years later were a screaming buy. One didn’t need to check for the latest movement up or down. Fast forward to today, and the question is whether oil now has reached a similar buy-first-and-ask-questions-later moment? The answer: not even close.

Just because prices have fallen 20% to a four-year low since President Donald Trump arrived at the White House doesn’t mean that oil is a bargain. It does mean, however, that it’s cheap. Historically, one can argue that it is, in fact, very cheap.

At around $60 a barrel, West Texas Intermediate, the US benchmark, is trading at a similar level as it was 20 years ago. And that’s in nominal terms. Account for inflation, and oil, in real terms, is trading at the same level as it was more than 40 years ago.

But oil futures can still drop further. What’s cheap could become cheaper. Right now, the market is pricing in an economic slowdown and more-than-expected OPEC+ production. But oil traders aren’t pricing in either a recession in America — let alone in China — or a full-blown Saudi-instigated price war. And they aren’t pricing a combination of both a recession and a price war. If those risks materialized, WTI can easily drop below $50 a barrel well into the $40s and even the $30s.

Another question, though, is whether oil can drop below $50 a barrel — so, about $10 below where it traded on Friday — and stay there for a long period, measured in years rather than months. The answer is almost certainly “no” because supply and demand will rebalance quickly at those levels. And that opens investment opportunities for the brave if prices decline a bit further. For those with the stomach to weather significant but temporary mark-to-market losses, forward oil contracts for delivery a couple of years from now are approaching attractive levels. Think about WTI in December 2027, for example.

The problem is we haven’t seen a market yet that suggests true capitulation and thus offers great entry points. Before Trump partially reversed course on tariffs on Wednesday, the vibe was approaching that of every-trader-for-themselves. Still, at current levels, forward oil futures aren’t a risk-free bet.

At the worst point last week, the two-year forward WTI price was $58.22 a barrel; back in 2020, it traded as low as $33.75. Even ignoring the bleakest period of the pandemic, when the global economy shut down, the two-year WTI forward traded below $50 a barrel for nearly 350 days. It’s often good to review the price chart to see how low prices can go.

Still, a cycle doesn’t last forever. Oil tends to recover from economic downturns relatively quickly as low prices hurt supply growth and propel demand. That’s why it sees boom-and-bust cycles. “Sadly, this is familiar territory,” Houston-based oil banker Dan Pickering says. “The catalysts are always different, but the playbook is well established from the downturns of 1986, 1998, 2001, 2008, 2014 and 2020.”

What’s the argument to use the dip to buy long-dated oil futures?

1) Although 2020 taught us all a lesson of how low the market can go, the current economic instability is very different: It’sa trade war, not a crushing pandemic that froze large chunks of the global economy. Look at the debate about the impact on oil demand growth. So far, it’s about a slowdown; perhaps a small contraction, but nothing more than a 1% drop at worst. Five years ago, global demand contracted by 20% at the worst point.

2) Current prices are probably down enough to trigger a supply response as the US shale pain threshold has moved higher. On average, American shale companies say they can’t drill profitably below $65 versus $49 in 2020, according to a regular survey conducted by the Federal Reserve Bank of Dallas. Further price declines will only exacerbate the supply response.