Oil is Dirt Cheap. Should You Start Buying?

The point of investing is to buy low and sell high. Of course that's easier said than done. What's the latest market to pique value buyers interest? Oil.

If you drive a car, heat your home, or follow the news, chances are you've noticed that oil prices have been in a nosedive. The price of a barrel of West Texas Intermediate crude oil, which in July 2014 fetched $107 a barrel, has slid down to around $30.

Energy companies, as a result, have had a rough go of it. iShares North American Natural Resources , an exchange-traded fund that invests in a panoply of oil producers, has lost 31% of its value over the past year. Even large banks like Wells Fargo and J.P. Morgan Chase are seeing some loans to oil producers go bad.

Supply & Demand

The fact is, major countries around the world may need less oil in the near-term. China's slowing economy, tepid growth in Japan and Europe, and ongoing trouble in the emerging markets lead traders to doubt that a big rebound in prices is imminent.

On the supply side, there isn't a lot of reason to believe there will be a shortage anytime soon.

Ellen Lee, a portfolio manager at Causeway Capital Management, expects "oil supply to remain about flat year-over-year," according to a recent note.

New production is likely to be limited since the reward isn't worth the cost of getting the stuff out of the ground with oil prices so low. But Iran's return to the market after years of sanctions will likely offset that decline.

In Search of Rock Bottom

Throughout the year-and-a-half decline, investors have been trying to anticipate the bottom in prices. For instance, investors poured $1.8 billion into Energy Select Sector SPDR ETF from Nov. 20 through Jan. 7 of this year, according to Bloomberg and SSGA, as oil prices dropped 16%. As the price fell another 9%, investors pulled $1.2 billion out.

"Investors are looking to find the bottom," says Dave Mazza, head of research for SPDR ETFs and SSGA funds. "Investors have proven wrong so far, but it hasn’t turned them away."

USAA Investments portfolio manager John Jares believes today's low price is more of a result of oversupply, than a lack of demand.

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Saudi Arabia and other OPEC member nations didn't significantly reduce production as the price declined because they didn't want to give up market share to competitors. Instead they're trying to drive the price low enough so that it's not worth it for producers in, say, North Dakota or Oklahoma to frack black gold out of the ground.

As the level of U.S. production declines — which is expected this year — along with other nations like Russia, prices will begin to creep back up.

In addition to concerns over supply and demand, many investors view oil prices as the canary in the coal mine, says Jares. "Rapid decline in oil prices has scared people since they view oil prices as a barometer of the global economy," he says, "In 2008, for instance, oil prices weakened along with the economy."

Is this the end of it?

"We've probably seen the bottom," says Jares who thinks energy could reach $40 to $60 per barrel this year. That's in line with Causeway Capital Management's estimate of $45 per barrel. But don't expect oil to jump back to $100, says Jares, since U.S. production will ramp back up once the price increases.

How Should I Invest?

One reason investors are so interested in predicting the bottom is because the stock market tends to rise once the oil tide turns. Low energy prices basically amount to a tax cut for consumers, but it generally takes a year or so for those savings to translate into increased spending.

"There is a lot of history and supportive information to suggest that following the oil price shock, the U.S. economy will be more robust," notes David Kotok, chief investment officer at Cumberland Advisors. "The upward movement will be reflected in an upward movement in stock prices and higher and higher total returns, with a strongly positive number from the S&P 500 Index."

Investors who own a passively-traded mutual fund that tracks the S&P 500 already have 6% exposure to energy. If you want to make a bigger bet on the sector consider iShares North American S&P Natural Resources , which outperformed the market in 2009 and 2010.

Just don't expect any miracles.