Why You Should Not Be Betting On a Rebound in Oil Prices

With the price of oil falling below US$50 per barrel, the rout in oil prices has shown no signs of abating. But, I don’t think that would stop many investors from wanting to invest in oil-related companies on the premise that oil would rebound soon.

For such investors, they’re missing one very important point: No one knows where the price of oil is going to be. When it was hovering between US$80 and US$100 per barrel in the earlier part of 2014, no one predicted that oil would be lesser than US$50 today.

Sure, the price of oil may very well rebound shortly and make an investment in oil stocks very profitable. However, if our investment thesis is one based on a prediction of when the price of oil would rebound, it is nothing more than just a speculative bet.

The right steps ahead

Lower oil prices will surely affect oil and gas-related companies. Let’s take Ezra Holdings Limited (SGX: 5DN) and Ezion Holdings Ltd (SGX: 5ME) for instance. Both firms provide support services to the oil and gas sector and their revenues would thus be affected by the capital expenditures of the upstream players (the producers of oil & gas).

But, an oil company’s ability to grow its revenue and profit depends on more than just the price of oil alone. The capability of the company’s management team plays a major role too.

The importance of independent thinking

For companies which face lots of pressure from macro-economic forces (such as firms in the oil & gas industry), their management’s ability to resist the “institutional imperative” is of great importance. This is how Warren Buffett once described the institutional imperative:

“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’ In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.”

Prudent management

If we tie the institutional imperative back to oil companies, it would look something like this. During the boom times, many oil companies would expand rapidly so as not to miss the train. And in order to capitalize on the opportunities fully, some firms would leverage their balance sheets and take on excessive debt in order to expand as quickly as possible. Such management teams are examples of those who have not taken precautions to protect their companies against any downturn in the industry – in other words, they’ve failed to fully consider the risks.

With the huge drop in the price of oil, oil-related companies with high debt loads would be the ones which find themselves in the deepest trouble. And if they really do end up in trouble, it is only because their management teams were not able to resist the institutional imperatives such that they ended up expanding blindly and dangerously. These are the oil companies we should avoid. Meanwhile, those that did the opposite – those that expanded prudently and displayed independent thinking – are those we should consider.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim does not own any companies listed above.