Why investors shouldn't 'buy on the dip' amid this oil price downturn

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  • In the past, private-equity firms focused on energy have used a simple approach to investing: "Buy on the dip."
  • But after the last downturn, starting around 2014, many of those investors got burned, according to Adam Waterous, the founder of a $1 billion energy investment firm. 
  • Today, when oil has fallen by about 50%, private investors may again see this an opportunity to buy on the dip.
  • But Waterous cautions that this approach will likely lead to poor returns.
  • Visit Markets Insider to view the latest on oil prices.

It doesn't take a skilled investor to understand the theoretical value of investing in the energy industry when oil prices are low. Like the broader stock market, oil prices are cyclical — they tend to rise after they fall.

In fact, most major analysts now say oil markets are poised for a recovery that could yield pre-pandemic prices sometime next year. So why not invest in cheap energy companies now, which have profits that are directly tied to an oil price bounce-back? 

As appealing as that approach may be, it can get investors "killed," said Adam Waterous, the founder of a $1 billion energy fund based in Calgary. 

"There can be a real simple desire by investors to so-called buy on the dip," said Waterous, the former head of investment banking and North American energy and power at Scotiabank. 

But during the last downturn, buying on the dip, "led to a lot of investors losing a lot of money," he said. And this one isn't very different.

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Gas flaring at a site of Whiting Petroleum in Stanley, North Dakota. Whiting was the first major oil company to file for bankruptcy in the wake of the oil market meltdown.
Germain Moyon/AFP via Getty Images

It may be hard to imagine today, but the period from 1970 to around 2009 was considered an "age of scarcity" for oil, Waterous said. During that time, the dominant view among energy investors was that oil would become increasingly precious.

With that mentality, oil companies reinvested profits into expanding production, and, aside from some of the majors, they did not offer dividends. Instead, private investors — who were behind much of the industry's capital — sought returns through mergers and acquisitions. 

For a while, this strategy worked.

Starting around 2009, in the aftermath of the financial crisis when oil was cheap, loads of private investors saw an opportunity to buy on the dip. They poured billions of dollars into the industry and, leading up to 2014, saw big returns on capital that averaged around 8% to 10% as the industry recovered, Waterous said.

Then around 2014, the price of oil started crashing again. Driven by both an oversupply and drop in demand, US crude fell from over $100 a barrel in 2014 to less than a third of that at some points in 2016.

To many investors, it seemed like another good opportunity to buy on the dip, Waterous said. So they did, backing the industry with $20 billion to $30 billion a year from 2014 to 2016.

Ruobing Su/Business Insider

But this time, the returns never materialized. 

By funneling money into the US shale industry after 2009, private investors, in some ways, spelled their own demise.

All of that money fueled the growth of a technology known as hydraulic fracturing. Using horizontal drilling, a perforating gun, and pressurized liquids, fracking allows drillers to extract oil and gas trapped inside shale rock.

"Overnight, the industry went from being drilling-location poor to drilling-location rich," he said. 

The fracking revolution made America the largest crude oil producer in the world. But at the same time, it also made finding and extracting oil easier and less risky, Waterous said.

As a result, companies focused on that task — the very companies backed by private equity firms — were much harder to sell, especially if they were producing lower-quality oil, he said. 

Without M&A, investors had no way of getting returns. Instead, they had to hold onto companies, many of which weren't profitable. Making matters worse, the price of oil never fully recovered, even before the pandemic took hold. 

"The industry was just vaporizing capital," Waterous said. "Many people who bought on the dip and said 'Hey, I've seen this before' got killed."

The structure of the industry hasn't changed much since then, he said. And now, there may be even fewer buyers. 

"Just because prices have come down, you have to be very careful about where you're investing, just like you need to be careful in 2014 and 2015 when a lot of money got lost," Waterous said. 

Of the 500 or so oil and gas companies backed by private equity firms in North America, Waterous said he thinks an astonishing 80% of them won't be able to find a buyer. Without access to more cash, they'll be forced to stop spending on their oil assets, causing production to decline.

"This is going to be a smaller industry going forward," he said.

Waterous said he has no doubt that oil demand will return. In fact, he thinks US crude oil prices will rise higher than they were at the start of the year, in the wake of North American production declines that are limiting supply. 

"But getting from here to there, a lot of companies are going to cease to exist," he said. "It's tricky investing in a shrinking industry." 

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