The Big Oil Crash of the 1990s

It is critical for long-term investors not to be swayed by what other people think, what the rest of the world thinks, or anything like that. This is obviously easier said than done. I’d like to direct your attention to the cheap oil of the 1990s, and discuss three things: the headline risk that existed at the time, the investment returns that occurred during this time, and the changes in the price of oil’s fundamentals that occurred during this 1990-1998 time frame.

In September of 1990, the price of oil spiked to $60.57 per barrel (I’m giving figures that are adjusted for inflation using 2014 statistics). This was a significant uptick from the $35-$40 range that was the world’s oil price habit during the last five years of the 1980s. Saddam Hussein had accused the Emirate of Kuwait of using slant drilling techniques to steal Iraqi oil, and this price spike occurred during Iraq’s seventh month occupation of Kuwait in which Saddam Hussein ordered his troops to burn down over 600 Kuwaiti oil wells.

The common narrative of the time suggested that infighting between third-world regimes would destabilize the international supply of oil, and unsteady demand would create a new normal in which vehicle owners would be paying about 30% higher prices compared to the previous normal.

The conventional wisdom of the time urged investors to buy oil stocks under the theory that the crisis would extend indefinitely and oil prices would remain high, and other commentators cautioned that oil stocks should be avoided and the crisis would be temporary, saying “It’s not like we are going to see $2 gas on our lifetime.”

What prediction proved correct? Neither.

The spike in oil prices lasted less than nine months as the United States intervened to secure future oil supplies and restore market confidence. With OPEC countries increasing their production, the rising supply was met by a stagnant demand as population growth in 1990s America occurred in the cities (breaking a four-decade trend of suburban expansion.)

As a result, the price of oil got so cheap that the per barrel cost hit $16.42 in December 1998. During this eight-year measuring period from September 1990 through the end of 1998, the price of oil fell by two-thirds. You would assume that this decline in fundamentals would be accompanied by poor performance among the oil majors.

But this intuitively appealing assumption would be wrong. In fact, it was one of the most historically lucrative times to invest in oil stocks in American history. ExxonMobil delivered 18% annual returns during this time frame, well above its 14% annual return average since the end of World War I. Chevron delivered 14.5% annual returns during this time frame, about two percentage points better than the company’s returns since 1965. And Phillips 66 returned 12.5% annually during this time, about four points annually better than what you’d get through an index fund.

Someone that became an owner in Chevon during the start of the Iraqi invasion in 1990, and reinvested for the next eight years, would have ended up collecting almost $1,000 in annual dividends for every $10,000 invested at the start of this eight-year period.

The business performance was excellent, but the day-to-day commentary indicated a lot of uncertainty. Many pundits advocated the purchase of oil stocks in 1990 under the theory that oil supplies would be destabilized and oil would be prohibitively expensive. While the prediction that oil stocks should be right was spot on, but the rationale was not correct. If you needed to see oil prices rise to hold onto your shares of Exxon, Chevron, and Phillips 66, you would not have seen the fundamentals match your investment thesis and you would have possibly sold at some point during this period of outperformance.

Likewise, if you avoided oil stocks because you thought the price of oil would be cheap during this period, your thesis that prices would be cheap would have proved correct but your understanding of the total return implications would have been wrong.

The success of oil stocks during a measuring period that saw the price of barrel decline by two-thirds should give pause to people that think they can be traders and buy and sell oil stocks in response to trends. Moving into and out of stocks requires you to accurately predict oil production/supply trends (and the whims of cartels such as OPEC), global demand (and changes in technology that can affect it), military/government interventions, and you have to tie all of these predictions to a specific time range. Furthermore, even if you do predict those elements correctly, you have to also accurately predict how those factors will impact total return. There are a lot of ways to make a mess of your investment principal reacting to the latest trends in oil stocks.

That is why I recommend comes close to a no-nothing, dollar-cost-average approach with the oil majors. There have been four or five years in the past fifty when you can look back in hindsight and say, “Yeah, that probably wasn’t a good time to load up on Big Oil.” Most recently, the summer of 2008 was not a good time to make a large oil stock investment–you would have basically been collecting your dividend payments, and that would be the extent of your total returns.

The buy-and-accumulate approach is not only the most lucrative, but also the most stress free. The simple thesis of: “The world needs energy. These companies produce. The forms of this energy, and the prices of it, will fluctuate over periods of time. Tolerance for this volatility will create a lucrative payoff down the road for those who wait.

It continues to amaze how the headlines you see on CNBC can be quite different from the returns of a real buy-and-hold oil investor doing his own thing out in the wild. On August 24th, the price of Chevron stock dipped below $70. If you turned on the television, the pundits were only comparing this price to the previous year’s high of $135. That prism of the oil markets looks like a random, scary place where you can lose a lot of money in a hurry. But the investor that owned Chevron stock since the invasion of Kuwait–buying after a 30% hike in the price of oil–would be collecting $2,500 quarterly dividend checks on a $10,000 initial investment by the third quarter of 2015. That was a real check that would have been put in the mail or sent through as an electronic credit on September 10, 2015.

When you own $180 billion in oil reserves and produce over a million barrels of oil per day, and only carry moderate debt on your balance sheet, you are going to be around for a long time. That is the case with Chevron, Exxon, as well as Conoco + Phillips 66. Royal Dutch Shell has more production and higher than industry average debt, and BP has the highest debt of all, but their staying power is overwhelmingly likely as well (the real risk of permanent capital impairment would be if BP or Royal Dutch Shell experienced another oil spill similar to BP’s 2010 Gulf Oil one that racked up a substantial new liability during a period when oil prices are low.)

Oil investing requires a time horizon measured in decades. I would not want to invest in oil for a time period shorter than that, as there is a risk that the total returns will be random and not a reflection of the historical fundamentals in the industry. The beauty is that the dividends are higher than you’d get from most other S&P 500 stocks, and the stocks in this industry rarely get overvalued, so the power of reinvesting dividends can only be matched by what the tobacco saw during the latter half of the 20th century. People who buy these oil majors, and reinvest the dividends for 10+ years, tend to see these companies in a cash cow light that almost every member of the financial media ignores.