Crude Oil Approaching $100 - Dynamics of the Oil and Energy Markets

By: Andy_Sutton

As oil prices continue to forge higher highs in a seemingly inevitable journey to the $100/barrel mark, it becomes more important for individuals to understand the dynamics of the oil and energy markets. Typically, people think of the price of oil and related energy products from an expense perspective. They worry about how rising gas prices will affect their budget for instance. Or, for those who use oil to heat their homes, they struggle with the ever-increasing cost of heating oil pre-pays. However, there is some good news here also. It is possible for rising energy costs to affect the income side of your personal ledger too. Since oil prices are constantly in the headlines these days, it seems timely to discuss some of these investment possibilities in greater detail.

Traditional Production Companies

Overview

These are well-established companies that produce oil and/or natural gas from existing reserves. They produce their products and sell them on the open market. Many of these companies are multinational and operate in different geographical areas.

Advantages

These companies have a pool of reserves that they produce from. So there is an element of stability. Many have a tendency to acquire smaller companies in order to continue growing those reserves. Emphasis should be given to those companies who are able to effectively grow their reserves. In a peak oil world, this will become more and more important, especially in the long run. Most of these companies pay a small dividend.

Disadvantages

Capital appreciation can happen slowly. Dividend yields are generally not high (Usually less than 5%). These stocks are generally lower in terms of risk, but are still sensitive to the price of oil. Special attention must be paid to market risk. Recently, political risk has become an issue as there have been several cases where companies put capital into a project only to be dismissed with extreme prejudice by the host country. Or had the terms of their agreement changed in ways that made it no longer economically feasible to continue the operation.

Exploration Companies

Overview

Exploration companies focus on using various types of technology to find new reserves. Sometimes they explore existing oil fields looking to drill additional wells or extract additional resources, but often they spend the bulk of their capital looking to find new sources of reserves.

Advantages

The potential for profit growth is enhanced. Any oil/gas that is found and proven will increase the likelihood of capital appreciation. Another positive is that these firms often become targets of acquisition since larger companies often take the stance that it is easier to buy reserves rather than going out and finding them.

Disadvantages

Risk. Pure and simple. Drilling is an expensive and risky business filled with uncertainty. Many ventures fail. The possibility of loss of investment is significant. The potential for reward should be commensurate with the amount of risk taken. Many of these operations go on in inherently unstable parts of the world. Political risk is a real concern. In this regard, exploration companies and traditional producers have much in common.

Royalty Trusts

Overview

Royalty Trusts are generally involved in some type of mining or drilling operation. These types of trusts generally own oil or natural gas wells, or the mineral rights of such wells. The companies are generally traded publicly on easily accessible exchanges. Royalty trusts are taxed in a more favorable manner as long as the lion's share of the profits are distributed directly to the unit/share holders as dividends. The obvious benefit is that double-taxation of corporate profits is avoided.

Advantages

Royalty trusts typically pay high yields which serve to attract investors. For this reason, the individual investor must consider interest rate risk when investing in royalty trusts. As interest rates rise, this can make these types of trusts less attractive. The opposite is true when interest rates are falling.

Disadvantages

The value of royalty trusts as previously mentioned is sensitive to the interest rate environment. There is also market risk involved. A sell-off in crude oil for example can lead to disproportionate devaluation in the trusts. Since trusts are becoming more and more popular and far-reaching, one needs to consider the potential for political and economic risk as well. Recently, Canada proposed treating Royalty Trusts less favorably with regard to taxes. This caused the value of many trusts to erode significantly. Many have since reclaimed the lost ground, but the situation serves as an excellent illustration of the risk potential.

US vs. Foreign Companies – Food for thought

As has been fairly well publicized of late, the US Dollar is breaking down against almost all major currencies. This means that our dollars buy less overseas. Since many of our products originate overseas, we lose purchasing power as our dollars decline in value. The same goes for our investments. This alone is a compelling reason to invest at least some of your portfolio outside the US currency. When the money outside the US is repatriated back into US dollars, the investor is ‘compensated' for the loss in dollar purchasing power. For example, the Canadian dollar has appreciated over 14% against the US dollar over the past year. Assuming one purchased an investment in Canadian Dollars last year and assuming the investment itself didn't grow at all in that year, the hypothetical investment STILL gained over 14% just on the currency move alone. Currency risk has become a fact of life and MUST be considered when making any investment energy-related or otherwise.

We have lived in an environment of increasing oil prices for much of the first part of the new century. Supply and demand dynamics, monetary inflation, and speculation have all contributed to this environment. Moving forward we need to ask ourselves if the conditions that have caused the current environment are likely to lessen, stay the same or intensify, then make appropriate investment decisions based on those beliefs. The goal is to create a balanced portfolio of assets that fits our investment goals and our risk tolerance. If we are able to position ourselves accordingly, the news of new record high oil prices doesn't need to be all bad.

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.

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