Buying Into Black Gold, For The Long-Term

28th Jun '14 by Edmund Shing

2 comments 6738 reads

Oil As a Strategic Long Holding

Here are some reasons why I think that the Energy sector and Oil is still an excellent long-term investment theme for some time to come, with a couple of short-term drivers to drive oil-related commodity and share prices to boot...

1. Seasonal Effect - US Gasoline Prices Break Out For Summer (Driving Season)

Source: St. Louis Fed, Bloomberg

Energy: The Long-Term View

2. Long-Term Oil Driver: Consumption Growth from China, India etc.

3. So far, Non-OPEC (North America) Production Growth Has Kept Up

4. But Will Be Tough to Keep Up With Demand...

Energy: Short-Term Risks

5. Iraq, already OPEC's 2nd-Largest Producer, Is Forecast Huge Production Growth

6. With ISIS Advances, Iraqi Civilian Deaths Now Highest Since 2007

Investment Conclusions

7. Buy US Integrated Oil, Oil Services, MLP Stocks on Weakness

(JPMorgan MLP ETF: US code AMJ;

iShares Oil Equipment & Services ETF: US code IEZ)

8. Buy US Oil, LNG Shipping On US Export Growth

(Guggenheim Shipping ETF: US code SEA;

Teekay Corp. (US code: TK)

Summary

The Oil Sector Remains A Key Long-Term Investment Theme
World energy demand to grow fast
Short-Term: Geopolitical Risks to OPEC Oil Production (Iraq)
US, European Oil Stocks to Continue to Outperform
The PowerShares DB Commodity Index ETF (US code DBC) one way to play higher Brent crude oil, gasoline prices.

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Cuthbert C

28th Jun '14

As you know I subscribe to the underlying investment proposition which says that oil prices are likely to remain strong and indeed increase over time.

That is, however, the easy bit. The hard bit is how investors can use that insight to make money. And that's where I would take issue with you.

At least one of the investment conclusions summarised above do not in my opinion flow from the preceding proposition.

"Buy US integrated oil" - how does this flow from the antecedent? Integrated oil companies have business models like seesaws. When oil prices are low the marketing and refining divisions tend to make more profit whilst E&P do badly. When oil prices are high the situation is reversed with M&R suffering whilst E&P does well. Theoretically in an integrated company which was perfectly balanced, its results would not be affected by the price of oil. Of course none of them are perfectly balanced so it gets more complicated than that, but you see what I mean.

As a minimum a coherent investment proposition needs to consider the balance between the various divisions of an integrated co before reaching any conclusion about the effect of the oil price. You might have heard the apocryphal story that Shell makes more profit by selling sandwiches on its forecourts than it does by selling fuel in retail outlets. I doubt it is true , but there is a serious point there.

At its simplest I would ask the question - have the majors done well in the past 10-20 years since the oil price surged? It does not seem so to me. And that is perfectly understandable in my eyes.

I remember Warren Buffet pointing out that the global airline business since the start of aviation had, in totality, been loss making - despite the undoubted operational success of air travel. A similar observation might be made of railways.

So if integrated majors are not the way to play a strong oil price - what next? The obvious answer is E&P where the weak end of the see saw is not holding things back. But the stock market performance of E&P has been lamentable for years now. Clearly the valuations of E&P companies have become decoupled from the price of oil. The reason seems to be the funding crisis resulting from recent problems in the financial system coupled with the withdrawal of large scale investors and lending institutions.

I suppose what I'm saying is that I agree with you about the price of oil but I fear the market for oil co shares might remain irrationally depressed for longer than my own investment horizon. (I've been investing in E&P for 20+ years and will be dead or decrepit in another 20) .

My own investment strategy is based on stock picking where I try to select E&P's with

1) good assets
2) good management
3) adequate funding
4) alignment of interests of management and investors

This is why my own largest holding is SOCO - where I feel that all four of these factors is well and truly ticked.

Finding other E&P's which score 4/4 is much harder than one might expect and I find myself compromising and then being disappointed by the outcomes.

guest

30th Jun '14

Hello Tournesol,

I can fully agree with your stock assessment of smaller oil E&P players like Soco, I like Caza Oil & Gas and Lonestar Resources (Aust.) for similar reasons, to get cheap exposure to US shale oil production.

However, while I agree that integrated oil companies will never have the same leverage to crude oil prices that you can get from E&P companies, this is not suitable for the majority of investors as they do not have the necessary risk tolerance.

This is why I suggest integrated oil companies - as generally, they are less volatile than E&P companies due to their size and mixture of offsetting downstream/upstream operations, plus the generous dividend yields on offer from many of them. Companies such as Statoil and even Total look good large-cap dividend and value plays to me, particularly if Iran opens up further (for Total).

So I would say that it is horses for courses, and depending on your investment goals and investment risk tolerance, there are different ways to play this oil theme...

I fully agree with your point on finding "good" smaller E&P companies - I find that too many of them are like hedge funds - you take all the downside risk as an investor, but too much of the upside reward goes to the management in many cases...

Edmund

Buying Into Black Gold, for the Long-Term

Oil As a Strategic Long Holding

Energy: The Long-Term View

Energy: Short-Term Risks

Investment Conclusions

Summary

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Edmund Shing

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