How to Profit from the Next Spike in Oil Prices

Earlier this week, British company Desire PLC (Pink Sheets: DSPMF) began drilling in an offshore block of the Falkland Islands. Immediately, Argentina President Cristina Fernandez de Kirchner let loose with a howl of rage, and the Summit of Latin American and Caribbean Unity issued a protest against the British company's drilling operations.

Argentina's claim to the Falklands had remained dormant since the war 28 years ago, yet the moment the drill bit touched seabed the years rolled away. This showed yet again that oil remains salient to international politics and the world economy in a way shared by no other commodity. So how should investors play it?

Nearly 18 months after the 2008 financial crisis, central banks worldwide still maintain the loose monetary policy they each enacted to counter the financial problems that resulted.

In the United States, interest rates remain at zero while inflation is already nudging above the 3.0% level. In Britain and Japan, interest rates are also close to zero, although in Japan's case the country has the excuse that inflation rates are negative. In the European Union (EU), the official short-term rate is 1.0%. China's interest rates are higher, but the Asian giant's M2 money supply rose 26% for the 12 months that ended in January. None of this monetary "stimulus" looks like it's being removed any time soon. So the bull market in commodities and energy is likely to continue.

Don't overlook the expansion in China and India's automobile markets. China's motor vehicle sales rose an astounding 46% last year to 13.6 million, leaving the United States - the world's second-largest market - in the dust. This year in China, motor-vehicle sales are expected to rise past 15 million vehicles - equivalent to the U.S. market in a good year.

India's motor vehicle sales have also been rising rapidly - topping 2.5 million in 2009 - and are expected to rise another 10% to 15% in 2010.  All those new cars need fuel, and that's why demand for oil has continued to advance.

Conventionally, we played rises in oil prices by buying stock in the major oil companies. The problem today 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 keep all but a thin sliver of the profits.

In country after country - including such attractive markets as Brazil - governments are continually renegotiating oil-production contracts to give themselves an ever-increasing share of the revenue.

A second possibility is to buy companies with access to high-cost reserves in stable regions. As the price of oil rises, the profits of those companies increase exponentially. The obvious example here is Suncor Energy Inc. (NYSE: SU).

Suncor is the largest producer of oil from the Alberta Tar Sands, with reserves of 1.7 trillion barrels of oil, as much as the entire Middle East. Suncor's price has dropped from its 52-week high near $40 a share. At roughly $29 a share, the company's stock is now trading at only 32 times trailing earnings, and even sports a dividend yield in excess of 1.0%. For a pure oil price play, Suncor is attractive at these levels.

A third possibility is to buy an oil-oriented 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 like the SPDR Gold ETF (NYSE: GLD). One ETF that's reasonably liquid is United States Oil Fund LP (NYSE: USO), which seeks to track the price of West Texas Intermediate Light, one of the main benchmark crudes. U.S. Oil has a market capitalization of $2.15 billion, so is reasonably liquid and has only moderate costs.

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. However, the tax regime of the 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. That means the U.S. trusts are generally more attractive.

One U.S. trust that I currently like is BreitBurn Energy Partners LP (Nasdaq: BBEP). BreitBurn is an oil-and-gas producer from properties in Michigan's Antrim Shale, California, Wyoming, Florida, Indiana and Kentucky, so it's pretty broadly spread.

BreitBurn suffered cash-flow difficulties early last year, so was forced to abandon its annual dividend of $2.08 per share. In addition, it was involved with a lawsuit of staggering incomprehensibility with another company, Quicksilver Resources Inc. (NYSE: KWK). However, the lawsuit has now been settled. And, in even-better news, BreitBurn has re-instituted its dividend at a level of $1.50 per share annually. That's a yield of over 10% at the current share price, and those don't grow on trees - the company is also selling at around two thirds of net asset value (NAV). Its only disadvantage as an oil play is that it hedges a substantial portion of its output, which makes earnings statements incomprehensible and can lead to record losses when oil prices rise. But a prolonged oil price rise is still good - it enables it to hedge future production at higher prices, thereby locking in operating profits.

Unlike the increase in gold and silver prices, which is primarily inflation- and speculator-driven, the increase in oil prices rise is largely demand-driven, caused by the explosion in automobile purchases and other oil use in the emerging markets.

If you ask me, that looks to be a pretty solid basis for expecting it to continue long-term -even if interest rates rise.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

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News and Related Story Links:

• The Evening Standard/iStock Analyst:
  Analysis: Falklands, the Final Frontier.
• Wikipedia:
  Cristina Fernandez de Kirchner.
• CNN.com:
  Latin nations seek unity in regional summit.
• Wikipedia:
  Antrim Shale.
• FalklandsWar.org:
  The Falkland Islands Conflict (1982).
• Wikipedia:
  Athabasca Oil Sands.
• Investopedia:
  Net Asset Value.
• Wikipedia:
  West Texas Intermediate Light.
• Reuters:
  Quicksilver Resources Inc. Announces Settlement Of Litigation With BreitBurn Energy Partners L.P. And Provident Energy Trust.
• BreitBurn Energy Partners LP:
  Official Web Site.
• Wikinvest:
  BreitBurn Energy Partners LP.