4 Reasons to Be Long Oil - And Nothing Else

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 |  Includes: CEO, COP, DBO, HES, MUR, RDS.A, STO, TOT, XOM
by: Generation Consulting

Oil recently dipped to 3 month lows on fears about global demand and currently hovers around $72 dollars a barrel (as of August 31st). Meanwhile, global economic and geopolitical concerns continue to lend themselves to a higher price per barrel in the coming year. The recent decline in the price of oil presents the investor an opportune speculative and defensive window, especially if oil continue to tracks demand destruction rather than inflationary pressures.

1. Big Oil provides high yields in a low yield deflationary environment.

The 1-yr UST pays .27% interest while the benchmark 10-yr UST recently dipped to an absurdly low 2.5% annual rate. Oil companies’ dividends far surpass these returns:

  • ExxonMobil (NYSE:XOM)- 3.0%
  • ConocoPhillips (NYSE:COP): 4.10%
  • Chevron (NYSE:CVX): 3.90%
  • Total S.A. (NYSE:TOT) 5.0%*
  • Statoil ASA (NYSE:STO): 4.10%*
  • Royal Dutch Shell (RDS-B): 6.50%*
  • CNOOC (NYSE:CEO): 2.90%*

*subject to foreign taxes

A $1,000 investment today in US Treasuries will profit $288 by 2020 while a similar investment in ConocoPhillips (assuming dividend is not reinvested) will guarantee at least yield a profit of $400. Although this ignores the security of the original capital investment, oil companies are currently “cheap”.

ConocoPhillips is currently trading at an 8.89 P/E ratio while TIPS (inflation adjusted US Treasuries- meanwhile, oil is more “inflation adjusted” than our government’s accounting of inflation) trade at 100x times payout – ratios that resemble the 2000 NASDAQ bubble. Notwithstanding the argument that any major depreciation in the price of Big Oil stocks across a decade-long time span would inherently signify major geopolitical and economic upheaval – meaning, all your other investments have blown up anyway and still makes your shift to commodities prudent.

Thus, switching from the largest entity in the United States by revenue to the third (ExxonMobil earns more dollars than 3+ Californias), you receive an extremely liquid commitment to collect an annual yield about 12x that of a 1 Yr US bill. Factoring that ExxonMobil profited $19 billion in 2009 (and estimates a 25% sales growth in 2010) - and that the United States government plans on losing 1.3 billion in 2010, perhaps a “flee to safety” should be into stakes of our most profitable institutions.

2. Big Oil provides safety and profit in an inflationary environment.

Yes, not only Harvey Dent’s coin lands “heads” no matter which way you flip it, so does investing in major oil companies. It is no secret that the United States currently runs record budget deficits, maintains record national debt, and holds a major negative balance of trade that is currently widening (ignoring the $5 trillion in Fannie/Freddie debt (likely), the $2 trillion in states’ debt (less likely), another $3 trillion for government pension shortfalls (not likely), and $106 trillion in Medicare, Medicaid, and Social Security shortfalls (ha!)). In the unlikely event we cannot grow the economy out of debt (under current conditions, 10% annual growth, larger than China’s, would be needed to pay the national debt by 2020), or the United States government is unwilling to double taxes or cut its revenues in half, the investor should consider the possibility (or the likelihood in Niall Ferguson’s, the guy who literally wrote the book on money, opinion).

Although an investor can continue to allocate his or her funds based on the deflationary argument, despite a commitment by US Fed Chairman Ben Bernanke to “strongly resist deviations from price stability in the downward direction”, similar commitments to quantitative easing in other industrialized (read: debtor) nations, and double digit inflation in developing countries, paper currencies have the general feel of becoming more bountiful in the coming years. Like gold, the price of oil should reflect these inflationary pressures but meanwhile contain a critical, essential, and practical utility and demand outside of speculation (though it can do that too).

In either case, there is hardly a situation in which I can imagine that the United States dollar, struggling against unprecedented inflationary pressures, will buy the same amount of oil in 2011 as currently in 2010. Even if the currency argument is ignored, the maintenance of the status quo on currency valuations will only add towards oil’s upward movement.

3. The geopolitical concerns surrounding the price of oil are, if anything, becoming more acute.

Even if we decide to roll our coin down the hall rather than flip, we should still expect a rise in oil prices. Have we so soon forgotten peak oil, global demand growth, and the geopolitical concerns that drove oil to $147 a barrel in July 2008? These pressures have only increased in 2010 as the world stumbles out of recession. Statistics from the US Energy Information Administration show that oil demand have edged to pre-crash 2008 levels while supplies remain relatively lower. Global demand continues to increase – I would link to refer to two astute articles published recently by Kevin Grewal and Tom Lydon on the matter. A recent report by the International Energy Agency reports that oil demand crew nearly 4x the rate of oil supplies in July, reminding peak oil fears. In fact, a report this month by Goldman Sachs indicates that “global crude oil demand may have exceeded supply in the past two months”.

Geopolitical concerns have only become more acute since 2008. China has recently begun (?) to dump US Treasurys to the tune of $24 billion in June and off nearly a hundred billion dollars since last year. Is China using this cash to buy US goods and services (I’m guessing no) and continuing its penchant (plan?) for purchasing foreign commodity assets? Remember, the country sitting on the world’s largest cash reserves is now the world’s largest consumer of energy.

Oil is still increasingly becoming more difficult and dangerous to obtain. The BP oil spill demonstrates the risks associated with deep-sea oil drilling. At the very least, the spill delays aggressive plans to expand drilling in the Gulf of Mexico and the Alaskan coast while requiring a shuffling of the composition of energy players in the area (read: higher costs). Oil production from the Gulf of Mexico consists of more than a third of domestic oil production, the dangers of which we most nervously watched this entire summer.

Meanwhile, 62% of the oil consumed in the United States continues to be imported. The list of foreign countries from which the United States imports oil remains impressive in its lunacy. Out of the top ten countries in which the United States imports its oil, two have openly anti-American agendas (Venezuela and Russia), two are failed states according to Foreign Policy magazine (Iraq and Nigeria), two are in precarious positions as they battle dangerous populations (Mexico and Saudi Arabia), two emerged from civil wars in 2002 (Algeria and Angola), and just two are stable democracies (Canada and Brazil). In fact, if we remove the top and the bottom of this list to create our average (manipulating the numbers, I know…) we have a failed state score average of 85.5 (compared to Greece’s 46 score), six states declared “not free” by freedom house, and six dictatorships (Iraq and Mexico, the blissful exceptions).

And these are our friends. Iran, the fifth largest country by oil production, is an open enemy of the United States. A recent article in The Atlantic by Jeffrey Goldberg titled “The Point of No Return” caused a stir in Washington circles the likelihood of an Israeli attack on Iranian nuclear sites within the next eight months. Looking for black swans? It only takes one destabilization to create an oil shock.

4. Oil M&A

Cheap credit, rising energy prices, and corporate profits have contributed to an uptick in M&A activity in Wall Street. 2,050 energy deals in 2010 have been announced by August alone totaling $292 billion in value. Analysts at Grant Thompson predict an uptick in M&A in the energy sector following the recent activity in other sectors and due to the increased regulation following BP’s Gulf of Mexico disaster. Although the debate rages between inflation and deflation, it only takes one petroleum producer to determine that we are headed towards an inflationary environment and, thusly, it would be prudent to assume debt now to purchase more hard assets.

Furthermore, state-affiliated oil companies are becoming more aggressive as petroleum is vital to national security. Korea National Oil Corp recently made a hostile bid for Dana Petroleum. Petrobras, Thai PTTEP, India’s ONGC, Russia’s Rosneft, Russia’s LukOil, among others have either eyed or made energy acquisitions within the past few months. There are few guarantees in investing but I would be willing to bet that if there are Western oil companies “on sale”, state-owned oil companies in the developing world, flush with cash, will be there to purchase them.

While the author refuses to speculate on possible acquisition targets, investors looking to play this should glance at this list and options activity for the respective companies.

As a firm believer in randomness, there is never a “sure thing” in the stock market (read: geopolitical odds market). However, investing in oil provides an attractive opportunity for investors to earn constant, relatively safe yields guarded against a possible inflationary environment.

Disclosure: Author is long XOM, PBR