We like crude oil exposure because it is relatively inelastic, has no easily replaceable substitute on a global level, and it holds a positive inflationary relationship. Further, we feel the subject is worth reviewing because of the world’s continued dependence on crude oil. Remember that historically the price over the long term has consistently increased. In our opinion every portfolio should always have some level of crude oil exposure and there are a variety of different options available to achieve this goal.
The Global Addiction
Crude oil is one of the most critical resources that the world cannot afford to give up. Civilization as we know it today depends on the principle belief that there will be available crude oil tomorrow for economic use. We readily admit that there are promising alternative energy projects under development and some are even in limited use. Still, if we stopped using oil tomorrow not one and or all of the alternative resources combined could satisfy the daily demand for crude oil at this point. Whether you take a short or long-term economic view the fact remains that crude oil reserves are limited and the demand is relatively inelastic.
A World Built For Oil
Unfortunately, one of the largest under-recognized reasons why the world cannot easily transition away from crude oil has to do with the heavy investment in oil infrastructure by both governments around the world and energy companies. These two groups have spent billions and billions of dollars over literally several decades to build an infrastructure network global in nature. Just imagine the potential cost to completely replace the current world infrastructure relative to crude oil. The cost would likely be astronomical, not to mention the time it would take to actually replace it. In sum even if another scalable and viable alternative existed it would still face substantial challenges to actual implementation.
Profiting From the Situation
Below we listed a few different ways to gain exposure and to profit from crude oil demand:
Option 1: Big Name Energy Company
One can buy a large energy company that primarily focuses on crude oil demand. The return here should be two fold since we prefer energy companies with a history of consistently paying dividends regardless of the global economic situation. This means the investor should receive an initial return on investment in the form of dividend payments. Second, if the price of oil goes up the stock price generally appreciates in a corollary manner. Our preferred BUY name here Exxon Mobile (NYSE:XOM) even though it has recently expanded into natural gas.
Option 2: Pipeline Partnerships
Oil pipelines generally operate as “unofficial” monopolies in their respective geographies in our view. This is due to the significant barriers to entry - such as costs to replicate - and the required regulatory approval process. Oil pipeline partnerships often provide a sizeable quarterly cash flow distribution to limited partners. It isn’t uncommon to see cash flow yield in excess of 5%. As well, oil partnership units generally appreciate in conjunction with any increase in crude oil prices. Our preferred BUY name here is Kinder Morgan Limited Energy Partners, L.P. (NYSE:KMP) with a current distribution yield of 6.26%. To be clear this firm operates more than just oil pipelines but in our opinion is best of the breed for the sector space overall. Please be aware that these partnerships carry unique and sometimes complex tax consequences that should be reviewed.
Option 3: Energy Royalty Trusts
Energy royalty trusts essentially own mineral wells, proven reserves, and or other mineral rights on certain types of properties. Relative to this article we are specifically talking about energy royalty trusts that focus on crude oil. Typically these trusts pay out substantial dividends (in excess of 5%) especially when the price of oil increases in the spot market. Our preferred BUY name here is BP Prudhoe Bay Royalty Trust (NYSE:BPT) with a current dividend yield of 8.64%. BPT currently estimates that it will be able to pay out royalties at least through 2024.
The amount of crude oil exposure to be taken on in any portfolio conceptually depends on where the price of oil is relative to multi-year historical prices. The fundamental investment concept of “buy low and sell high” remains tried and true in our view. Thus when oil prices are low one should buy more and when prices are high one should hit the road with profits in hand. Never forget that oil is cyclical in nature and that patience is required when dealing with it. Like anything each option listed above does have its own specific pros and cons ranging from high dividend yields to potentially complex tax consequences. In conclusion, we feel these three options are fundamentally sound ways to gain crude oil exposure for the portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.