King's Investment Analysis Topic #1: Oil

[blakfyahking]

Oil

Crude Oil or Petroleum, is a liquid substance composed of hydrocarbons. It is flammable and used as potential energy in various machines as fuel. Crude is found and mined from reservoirs found under the Earth's surface. Crude Oil is synthesized by various oil companies to make a wide assortment of products: from plastics, to jet fuels, to various grades of gasoline used in vehicles. Several countries owe their financial health to the presence of their oil reserves. Because oil is a product that is consumed in vast quantities in almost all countries in the world, it has become one of the most valuable commodities to financial markets and economies.

The prices of barrels of oil and availability of oil have a significant impact on financial markets. Oil is frequently a political issue due to countries having a tense relationship based on a necessity to consume crude oil. Recent oil prices have brought the topic of peak oil into serious discussion. Other alternative sources of energy will impact the usefulness of crude in the future.

Key terms:

Peak Oil - The idea that the maximum amount of oil will be extracted and synthesized oil production will forever decline afterwards. This concept has forced many to seek alternative sources of energy, and also causes concern for the wealth of "oil rich" countries that live off the rents of their oil reserves.

OPEC - Organization of Petroleum Exporting Countries. Headquartered in Vienna, Austria and founded with the intent to stabilize oil prices. The following countries are members: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, U.A.E., Venezuela. Political contention arises from dealing with OPEC countries because of spikes in oil prices, and being forced to deal with countries that are part of OPEC that are not necessarily allies. Ex. The US is a main importer of oil, but Iran is a member of OPEC.

Reserve Currency - Crude oil is priced in US dollars. A drop in the value of US currency causes oil to be more expensive in US markets. Also pricing in US dollars causes OPEC countries to lose money which has made those countries consider the idea of switching their reserve currency from US dollars to Euros. Oil prices also affect production of oil, because depreciation of the US dollar makes production more expensive for OPEC countries.

 

[blakfyahking]

Its Impact on Financial Markets

Oil is a commodity (see other thread about investment analysis). Since commodities tend to be staples, they are a good gauge to see how well the economy is doing.

Generally this is how it is broken down:

Commodities/Financial securities are sold in financial markets

Financial markets are formed by economies

Economies are formed by governments

That relationship should be understood when doing investment analysis, because it makes it easier to understand why the market reacts a certain way to specific news. An economy is different than a financial market, even though many people refer to both as the same thing. Just understand that there are economies of other countries that don't have a financial market (stock market) like Wall Street.

Crude oil prices are significant because as a commodity, you can use commodity prices to see signs of inflation. Inflation is a totally different topic. But just know that inflation tends to make production go down, which makes financial markets go down. It also kills consumer confidence, which also makes markets trend down.

Oil prices are an important indicator of future performance of the market, because many companies use oil in some capacity of their production of whatever product they sell. For instance, if you invest in a company that is in food service, the company will have to pay more for fuel for vehicles it uses to transport produce. That money from the company has to come from another source. It may have to issue more stock to raise cash, or it may pull more cash out of its own account to pay the higher fuel price. In doing so, the company may have to cut its dividend. The dividend is extra money paid out to stockholders(YOU). If a company slashes its dividend, its market value of its stock may decline. That means whatever stock you own will be worth less.

So higher oil prices make production more expensive for your company you are in investing in.

Attached is an article that breaks it down:

http://www.npr.org/templates/story/story.php?storyId=16211938

Oil prices have an inverse relationship with financial markets. The higher the oil price, the tendency for stock prices to drop. Spikes in oil prices happen when oil production is threatened, or when the reserve currency depreciates(US consumers will pay more to buy oil/gasoline). An incident in an OPEC country can cause a spike in oil prices(ie. war, government crises). Heavy traveling seasons can increase the demand for oil sharply, which can inflate prices. This demand usually occurs around hotter summer months(which is why gas prices tend to rise severely in the summertime). The demand for oil is not in equilibrium with the supply.

Oil companies such as BP and local governments influence the price of gasoline. Goverments attempt to tax companies like BP to influence them to lower gas prices. Crude oil prices rising make gasoline production more expensive for oil companies like BP. So BP passes the increased price of production onto consumers. Governments see these higher prices of gasoline making BP more profitable, so they tax to get more revenues. BP responds by increasing the price of gasoline. Plus the gas station retailer raises the price so that they can make a profit. Transporting gasoline is more expensive to city centers than to outlying country areas. This revolving circle of raising prices to keep profits is why the prices increase at the pump. SMH

This is also why it seems gas prices are higher in downtowns of cities.

 

[blakfyahking]

Investing in Oil and Oil related industries is not for the average investor

You have to have a little more investment saavy than most trying to play the market. Oil is a seasonal commodity, meaning that its prices fluctuate throughout the year. And oil as a commodity is very shock sensitive. This means that current events could easily impact the profitability of investing in oil. The only investors that should be seriously interested in investing in oil are those who have enough knowledge of shorting stocks and hedging portfolios, those who are willing to take a large enough hit to their portfolio and are still able to recover, and those who are knowledgeable about the oil industry.

If you are a bullish investor, then oil is something to be considered during the summer months in the US domestic market. If you are a bearish investor, oil is a good investment to "short" in the fall and spring months throughout the year. And even still oil prices can fluctuate in the fall.

The average investor should only focus on using oil prices as a sign of telling what is going to happen in the short term future in the stock market. Generally, when oil prices go up, production becomes more expensive, and it brings profitability for companies down. Also consumer confidence is dampened because consumers are reluctant to travel for leisure as much, which generally leads them to spending less money. All these factors usually mean the stock market will trend down. At the same time, when the stock market trends down, most of the larger investors will transfer their money to the bond market and commodities such as gold to preserve their portfolio. So when oil goes up, stocks tend to go down.

Still for those interested in investing in oil, your best bet is either "shorting" in the domestic (US) market, buying options in the domestic market, or buying an oil related mutual fund on exchange-traded fund in world markets, or if you are really looking at long term profits: American depository receipts (ADRs) in world markets such as China and India.

For long-term investors(1 year+):

ADRs = http://seekingalpha.com/article/180726-the-complete-list-of-oil-adr-stocks

For short-term investors(1-year or less):

Bonds = http://en.wikipedia.org/wiki/List_of_petroleum_companies.....at this link is a list of petroleum companies. you would have to research the company to find out about any bonds they are issuing

Mutual Funds = http://finance.yahoo.com/lookup?s=oil&t=M

ETN/ETFs = http://seekingalpha.com/article/101365-the-complete-list-of-commodity-etfs-and-etns

Options = Options are available on stocks with a market value higher than $10(see stock list)

Stocks = http://finance.yahoo.com/lookup/stocks?s=oil&t=S&m=ALL&r=3 (use the list of petroleum companies in the link I provided for bonds, it will be easier to narrow down suitable stocks by comparing the stock list in Yahoo finance with the other list of petroleum companies. A lot of options are in this same stock list)