The recent stock market crisis was always going to take some time to unfold. This crisis stems from a complex interplay between oil prices and the underlying fundamentals of the U.S. economy. The impending financial crisis in the euro zone is further adding to the headwinds faced by investors. It is clear that oil prices and energy markets are a primary catalyst for this crisis.
While energy demand is the primary driver for the emerging market slowdown, financial markets are also starting to move. During the past year, banks have been pulling out of commodity-based investments. Also, European financial institutions are increasingly reluctant to lend money to European oil companies. The problem is that as they reduce their exposure to oil and gas assets, oil prices will inevitably decline.
Over the past year, a number of financial institutions in the United States have reduced their holdings of energy stocks. It is possible that the financial sector is reacting to the higher cost of funding energy assets and is reducing its exposure to risky asset investments. Such a move will likely decrease demand for energy investments and energy assets.
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Oil Producers Have Already Picked Their Investment Targets for the Next Few Years
Further, oil and gas producers have already set their investment targets for the next few years. For instance, Exxon Mobil (XOM) is one of the most aggressive oil producers in the world. According to its latest 10-K, the company believes it can increase its oil and gas production by 8% annually over the next five years. Furthermore, Exxon Mobil believes its growth rate will be faster than that of oil prices.
Of course, Exxon’s growth target isn’t very realistic. If we consider the overall projections of oil production in the world, the company will only meet about half of its annual production target. But even if Exxon had the strongest growth rate, which is highly unlikely, the company would only achieve a 5% annual growth rate during the next few years.
There’s a Big Price Gap between Oil and Gas Investments
The major problem with investing in oil and gas is that there are major differences between crude oil and natural gas. A barrel of oil costs nearly $80 per barrel. However, natural gas prices are far lower. For instance, natural gas prices are near $2 per thousand cubic feet (Mcf). This means that natural gas investments in the United States only make sense when the price of oil is around $90 per barrel.
If we assume a $90 per barrel price for oil, the expected return from investing in natural gas should be around 7% for the next five years. But if the price of oil is only $90 per barrel, the expected return for natural gas investments would be 5% during the same time period. Hence, there is a significant price gap between natural gas investments and crude oil investments. This gap explains the considerable mismatch in the return for oil and gas investments.
The Market Must Understand These Hidden Risks
The fact that there is a significant price gap between oil and natural gas means that natural gas investments should be made only when crude oil prices are around $90 per barrel. This price point makes it likely that natural gas investments will provide a positive return.