By Martin Hutchinson
Contributing Editor
Money Morning
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.
