Rising Crude Oil Price Profit Plays

By: Money_Morning

Martin Hutchinson writes: Crude oil is knocking on the door of $80 a barrel. That’s not what experts have been expecting. At the start of the year, when oil prices were below $40, these experts predicted prices would stay there, or even decline a bit.

But the truth is, an explosion in the world money supply, particularly in China, has fueled oil-intensive growth and caused crude prices to reverse their decline of late 2008. This trend is likely to last for at least the next several months. So how should investors play it?

The underlying cause of the continuing explosion in oil prices is the loose U.S. monetary policy that central banks around the world put in to counter the banking crisis and have kept there. In the United States, interest rates remain at zero – even though inflation is already creeping up towards 3%.

In Britain and Japan, interest rates are also close to zero. In the European Union, the “official” short-term rate is 1%. Chinese interest rates are higher, but China’s total money supply (M2) rose 27.9% in the 12 months through September. So there’s a lot of money sloshing around, and this time it’s not going into stocks or housing, but into commodities and energy.

Don’t forget the expansion in China and India’s automobile markets, either. China’s motor vehicle sales are expected to surpass U.S. sales this year, rising around 35% to 11 million vehicles, while India’s have also been rising rapidly, and this year are forecast to be up 25% to 2.5 million. All those new cars need fuel, and that’s why demand for oil hasn’t weakened as people expected, but has continued to advance.

Monetary policy in the United States won’t change for some time – the U.S. Federal Reserve recently said so. That’s also likely to be true around the globe, maybe with the exception of an occasional quarter-point increase like we saw in Australia, recently. So oil prices are likely to continue rising for months to come.

The New Rules for Oil Investors

Traditionally, we play increases in oil prices by buying stock in the major oil companies. That’s not the way to go today. The problem is that the majors don’t actually have all that much oil.

Furthermore, much of the oil they produce is in difficult countries, and when prices go up, those countries tear up contracts to make sure they get all but a thin sliver of the profits. The experience of Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) in Nigeria, where contracts were renegotiated in 2008 until only 2% of oil revenue flowed to the company, is typical and will recur in other countries if prices stay high.

A second possibility is to buy companies with access to high-cost reserves in stable regions. As the price of oil rises, those companies’ profits will increase exponentially. The obvious example here is Suncor Energy Inc. (NYSE: SU), which is the largest producer of oil from the Athabasca Oil Sands in Alberta, Canada. The Canadian oil sands, also known locally as the “tar sands,” contain more than 1.7 trillion barrels of reserves, as much as the entire Middle East.

However, Suncor is currently trading at 105 times the most recent four quarters of earnings, and is even trading at 20 times 2008 earnings – a year in which the average oil price for the whole year was considerably higher than it is now.

A third possibility is to buy an oil-related exchange-traded fund (ETF). These have the disadvantage that the storage cost of oil is very considerable. So they can’t just buy the physical commodity, as the SPDR Gold Trust ETF (NYSE: GLD) does with gold.

One reasonably “liquid” oil-focused ETF is United States Oil Fund LP (NYSE: USO), which seeks to track the price of West Texas Intermediate Light, one of the benchmark crudes. That ETF has a market capitalization of $2.24 billion, meaning it is reasonably liquid and has only moderate costs.

The Trouble With Trusts

A final possibility is to buy shares in either one of the Canadian royalty trusts or one of the U.S. trusts whose primary function is to exploit known reserves of crude oil. These have the advantage of paying substantial dividends as the crude is extracted and sold.

They do have two disadvantages:

• First, the tax regime for Canadian royalty trusts will change in 2011; at present, it’s not entirely clear what effect this have on the dividends and earnings, but it will certainly reduce them.
• Second, some of these companies are hugely overvalued, given the amount of oil they control. BP Prudhoe Bay Royalty Trust (NYSE: BPT), for example, has the right to a 16% royalty on the output of the BP PLC (NYSE ADR: BP) oil holdings in Prudhoe Bay, AK, which have 55 million barrels of proven reserves. Do the arithmetic, and you’ll find that at a price of $75 per barrel, BPT has an undiscounted value of $660 million. However, its market capitalization is currently $1.7 billion. There’s probably some upside potential I’ve missed somewhere, perhaps from secondary extraction or from some possible new discoveries in the holdings, but I doubt if there’s $1 billion worth.

I’ll leave you with two possibilities – of U.S. companies with oil-and-gas holdings that seem attractive. One is Linn Energy LLC (Nasdaq: LINE), which has oil holdings in the Mid-Continent and Western regions, and which uses some of its cash flow to buy new properties. That has a 10.12% dividend yield; its main problem as an oil play is that Chairman Michael C. Linn hedged its entire output for 2009, 2010 and 2011 at more than  $100 per barrel last year. That’s a great deal, but it also means that the company’s sales prices are fixed for the next 27 months!

Another possible oil play of the same type is MV Oil Trust (NYSE: MVO). This has net profits interest in oil and gas properties in Kansas and Colorado, with approximately 1,000 producing oil-and-gas wells. It pays out all its income in dividends, so shareholders directly benefit from rising oil prices, as it appears to be un-hedged. In the third quarter, it paid 59.5 cents per share – which on an annualized basis would give it a yield of 13.5%.

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