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A Risk Analysis On Oil Dropping Below $80

Taking a contrarian position could yield strong returns if the idea is right and the right time. A contrarian idea might sound outrageously wrong at first, but would be profitable if proven to be true over time. There is another way to apply contrarian thinking. Listing outrageous and unlikely scenarios is a useful exercise in identifying and mitigating risk. One thought that comes to mind is the possibility for depressed oil prices. The European recession, the slowing growth in China, and the Fiscal Cliff in the United States could drive oil prices much lower.

Recent economic figures from China were mixed. Its Service PMI was above 50, but still dropped quite significantly over the last two months. Europe’s unemployment is rising as the economy slows again, and in the U.S., talk of the Fiscal Cliff is raising the level of uncertainty for markets. One might extrapolate from all of this to mean lower economic activity ahead. This would mean lower demand for energy.

What if Brent Crude Oil prices were to drop below $80? WTI Crude oil was $88.50. Brent Crude Oil was around $110 on December 4 2012. A drop in Brent prices would hurt profits for oil companies. The companies with the most downside would be those with high exploration costs.

Companies with a small market capitalization could see its market shrink further, especially if investors tend to favor big companies over small ones. A starting point for further investigation would be to look at the companies below:

Mid-sized energy companies were weak performers in the last month:

Conversely, companies with a low debt ratio should do relatively better. Using Kapitall’s Compar-o-matic, ExonMobil (XOM) and Chevron (CVX) have the lowest debt ratio:

Conclusion

The price of oil will depend on supply and demand dynamics, while macroeconomic factors will contribute to the direction for each. At the microeconomic or company level, excessive production levels by companies, low breakeven costs, and easy financing could be skewing the supply levels of oil. If there is a glut, and the winter proves to be warmer than average, investors should anticipate the possibility for lower oil prices.

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