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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Investing in Oil to Beat Inflation

Commodities / Oil Companies Jul 15, 2008 - 03:54 AM GMT

By: Mike_Stathis


Best Financial Markets Analysis ArticleAccording to Washington , the official inflation rate is around 4.1%. At this point, I think it's obvious most consumers know this data is wrong. Of course some people accept anything Washington reports, especially the agenda-driven “experts” on television who bring in media hams as cheerleaders to spread the ludicrous propaganda of a strong economy.

You don't need a Ph.D in economics or finance to know that inflation is approaching levels similar to those seen in the 1970s. In fact, those who have been formally trained in these disciplines are more likely to miss what is really going on because they've been programmed to think that fancy math is always superior to common sense. But they often neglect to consider the fact that new standards are continuously being devised to hide the real data - from inflation and unemployment numbers to GDP and poverty statistics.

Understand that most economists are in some way connected to the government. Economists in private industry often sit on Washington committees. Most academic economists too are pressured to accept government methods of data analysis without question, or else they risk losing federal grants, government consulting projects, or being appointed to sit on government committees. Washington has many ways to understate inflation. I'll list just a few:

  • Use of core inflation at selected times
  • Use of non-core inflation at selected times
  • Under weighing essential goods and services like food, energy and healthcare
  • Overweighing non-essential goods and services or those with highly variable need so as to neutralize the effects of high inflation of basic necessities
  • Use of hedonics
  • Changing the assumptions and methods of calculations every year to suit its needs

Despite Washington 's continued use of accounting gimmicks, the fact is that inflation is around 10% and headed much higher over the next several years. As we all know, inflation damages stock and bond returns. And for consumers, inflation takes its toll due to higher costs of goods and services without commensurate wage increases. Finally, inflation also decreases the buying power of savings. The Federal Reserve is supposed to protect consumers against inflation by raising interest rates in a timely manner. But apparently, they feel otherwise, choosing instead to protect its member-owners – the banks.

Canadian Oil Sands

I'm not going to go into the details of the Canadian oil sands because it's probably old news to most of you. But those who are not that familiar with this huge source of non-conventional oil should do some research. You might want to start by watching the 60 Minutes feature on it about two years ago. Some of you might know of the success of the oil sands from investing in Suncor Energy (SU). For those who are aware of the oil sands but have not yet invested, you need to ask yourself why.

Production and refinement of the oil sands is very expensive, somewhere around $30 to $35 per barrel. Much of the cost is in the very expensive and tedious refinement process, which consumes large amounts of natural gas. That certainly doesn't seem expensive right now, but a few years ago it was. With oil prices more than four times previous levels, billions of dollars have been invested into the oil sands region of Alberta to tap this huge supply of crude. Even China is building a pipeline to Canada .

While Saudi Arabia and other Middle Eastern nations have an average cost per barrel of $1 to $5, we cannot count on OPEC oil when needed. This is especially true with the conflicts in the Middle East . In addition, the world's largest oil field in Saudi Arabia has shown very questionable signs of peaking out, as have many of the world's remaining largest wells. So even if they wanted to increase output, it is doubtful they could meet increased demands for much longer. The only solution, at least over the next several years, is non-conventional crude. And finding it in Alberta requires very little effort other than scooping it up. The real cost and effort is in the refinement process.

So what does all of this mean? Expensive oil is here to stay for a long time. Higher demand for fossil fuels sparked mainly by Asia have forced oil companies to go for the expensive oil. That alone will serve to keep prices high. Now, with inflation at or above 10%, based on long-term global oil demand versus conventional supply as well as the high costs of non-conventional crude, oil will be high for some time. Therefore, I consider the risk-reward for oil trusts to be quite good. And when you factor in the high inflation rate, the oil sands present an exceptionally lucrative investment opportunity relative to the stock and bond markets. In fact, one of my largest positions is in these oil trusts and has been for some time now. My top two picks are Penn Growth Energy Trust (PGH) and Penn West Energy Trust (PWE).

U.S. Oil Trusts

Unlike the recent birth of their Canadian counterparts, America has its own oil trusts which been around for several years. A few have been around for nearly two decades. These tar deposits produce a somewhat similar type of non-conventional oil. Unlike the Canadian trusts, the U.S. trusts tend to offer a nice combination of high dividend yields along with long-term capital appreciation, although the dividend yields are typically not as high. Some of the best ones are Sabine Royalty Trust (SBR), Permian Basin (PBR), San Juan Basin Royalty Trust (SJT), and Dorchester Minerals (DMLP). There are also a few gas trusts like Hugoton Royalty Trust (HGT) and Williams Coal Seam Gas Trust (WTE).

In particular, Sabine Royalty Trust has an outstanding track record. You should note its strong increase in dividends as oil prices have soared, combined with its marvelous long-term capital appreciation. This implies that management does not hedge oil prices or does so conservatively. Alternatively, there is a chance that the company could be hedging but its production has soared, although the former possibility is more likely.

While I plan to continue trading in and out when opportunity arises (to lower risk and cost basis), I won't be bothered if I should get “stuck” in a trade since I will be collecting anywhere from 13 to 18% dividend yields as I have in 2008. The dividend yield of course depends upon two things – the price at which you buy these oil trusts and the amount of dividends that are paid out. Therefore, investors should look to those trusts that have shown a history of consistent or increased payouts. For the later reason, I have as my number one oil trust holding Penn Growth Trust (PGH).

Additional Considerations

Prior to investing in these trusts, you should note that the tax treatment for the Canadian oil sands is not the same as some of the U.S. oil trusts like Sabine Royalty Trust (SBR), Permian Basin (PBR), San Juan Basin Royalty Trust (SJT), and Dorchester Minerals (DMLP). They are either structured as limited partnerships or some other form of trusts different from the Canadian trusts.

For some, the U.S. oil trusts will be preferred. The only problem I have with new positions in these trusts is that I am not sure how much remaining oil they have. Some of you who have held these trusts for many years might have a better level of comfort and certainly a very low cost basis, which offers lower risk for further investment. Regardless, prior to investing in any of these oil trusts, you should ask your tax adviser how they are treated. If you do decide to gain some exposure, don't rush in all at once. But now is certainly a great entry point, as many of the Canadian trusts are approaching year lows.

In Part 2, I will talk about the risks of these investments.

By Mike Stathis

Copyright © 2008. All Rights Reserved. Mike Stathis.

Mike Stathis is the Managing Principal of Apex Venture Advisors , a business and investment intelligence firm serving the needs of venture firms, corporations and hedge funds on a variety of projects. Mike's work in the private markets includes valuation analysis, deal structuring, and business strategy. In the public markets he has assisted hedge funds with investment strategy, valuation analysis, market forecasting, risk management, and distressed securities analysis. Prior to Apex Advisors, Mike worked at UBS and Bear Stearns, focusing on asset management and merchant banking.

The accuracy of his predictions and insights detailed in the 2006 release of America's Financial Apocalypse and Cashing in on the Real Estate Bubble have positioned him as one of America's most insightful and creative financial minds. These books serve as proof that he remains well ahead of the curve, as he continues to position his clients with a unique competitive advantage. His first book, The Startup Company Bible for Entrepreneurs has become required reading for high-tech entrepreneurs, and is used in several business schools as a required text for completion of the MBA program.

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Books Published
America's Financial Apocalypse: How to Profit from the Next Great Depression . Condensed Ed. Copyright © 2007.
Cashing in on the Real Estate Bubble . Copyright © 2006.
America's Financial Apocalypse: How to Profit from the Next Great Depression . Copyright © 2006.
The Startup Company Bible for Entrepreneurs: The Complete Guide to Building Successful Companies and Raising Venture Capital . Copyright © 2004 and 2005.

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors before engaging in any trading activities.

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