3 Things Everyone Should Know About the Oil Industry

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3 Things Everyone Should Know About the Oil Industry Flickr user Jonathan C. Wheeler

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Oil’s importance continues to grow The history of oil dates back more than 4,000 years as asphalt was used to construct the walls and towers of ancient Babylon. Mankind continued to find new uses for oil as it was eventually used for heating and lighting. Photo credit: Flickr user John Nuttall.

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Oil’s importance continues to grow Today, oil is vitally important as it’s a key vehicle fuel and the building block of plastics. Each day the world consumes more than 90 million barrels of oil. Photo credit: Flickr user Deni Williams. Source: Phillips 66

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Because oil is so important to the world economy it has become an important commodity for investors. However, before investing in the oil industry there are three important things you should know. Photo credit: Flickr user Ben Klocek

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No 1. The Oil Industry is Cyclical Oil is a commodity and its price is largely driven by supply and demand dynamics. When those dynamics are out of balance the industry can quickly go from boom to bust.

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Boom, bust, recovery…and then repeat. Strong demand for oil = robust oil prices Robust oil prices = lots of cash flowing into oil company’s coffers Lots of cash = capital to invest in new wells More wells = more oil supply Eventually too much oil hits the market and oil prices drop Low oil prices lead to increase demand for oil starting the cycle all over again

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Boom, bust, recovery…and then repeat. Oil prices have been freaking investors out for 150 years. Since 1861 there have been: 88 years with a greater than 10% change, once every year and a half 69 years with a greater than 15% change, or once every 2.25 years 44 years with a greater than 25% change, once every 3.5 years 13 years with a greater than 50% change, once every dozen years or so

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No 2. The Oil Industry is Capital Intense The industry needs to invest trillions of dollars to keep oil supplies flowing. These investments are made not just to meet growing demand, but also to keep up supplies as older wells deplete. Source: Chevron Corporation

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The decline curve and the demand pull The worldwide oil production decline rate is estimated at an average of 5% per year In order to keep production steady oil companies need to invest in new wells to offset decline from legacy wells Meanwhile, global oil demand increases by about 1%-2% per year This combination makes the oil industry very capital intense as most oil companies reinvest all of their cash flow and then some into new wells

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No 3. Outside Forces Add Volatility Geopolitics, conflicts and natural disasters can quickly subtract from the world’s oil supply. Meanwhile, 40% of the oil market is controlled by OPEC. Iraqi oil fires after the first Gulf War. Photo credit: Flickr user Bryan Dorrough Photo credit: Flickr user Day Donaldson

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Forces beyond the market’s control Case Study: The Arab Spring engulfs Libya in civil war. In 2011 the Arab Spring spread to Libya causing the country's oil industry to shut down This resulted in the country’s oil production to fall from 1.5 million barrels per day (or 1.6% of global supply) to almost zero This caused the price of oil to surge from $75 per barrel to more than $125 per barrel Once production started flowing again the price of oil dropped to less than $95 per barrel

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Forces beyond the market’s control Case Study: OPEC Stands Pat OPEC usually balances its production with global supply needs When the price of oil plunges, as it did in 2008-2009, OPEC reduced supply As the price recovered so did OPEC’s output However, in late 2014 when the price of oil plunged again OPEC decided to stand pat sending oil prices down even further This time it chose to maintain its market share instead of maintaining a market price

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Conclusion: Investing in the oil industry isn’t for the faint of heart Photo credit: Flickr user DVIDSHUB The oil industry is critical to modern society. However, investors need to be aware that it’s highly cyclical, capital intense and subject to outside forces. This can cause a lot of unexpected volatility as well as a lot of profit potential.

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