3 Ways To Play Oil: Stocks, Oil ETFs And Diversified Energy ETFs

 |  Includes: BNO, CLR, CVX, USO, XLE, XOP
by: Hard Assets Investor

Despite being one of the best-performing commodities over the past year, crude oil has been overshadowed by the likes of gold and silver. Here’s how investors can profit from high prices.

Crude oil prices are back on the rebound after tumbling during the early part of August. Brent was last trading near $115/bbl, up significantly from August’s lows under $99. Prices are up 21 percent year-to-date and a whopping 51 percent from a year ago. That’s even more than gold, which is up 46 percent year-over-year.

West Texas Intermediate ((NYSE:WTI)) remains at a steep discount to Brent due to pipeline bottlenecks in the U.S. Midwest; those prices were last trading near $89, up 20 percent from a year ago.

Despite the strong performance in crude oil prices, the commodity has been overshadowed this year. In the commodity space, gold has received much more attention, as the metal surged for an 11th straight year on the back of sovereign debt worries.

Perhaps WTI’s relatively poor performance has confused some investors. But the fact is that outside the U.S. Midwest region, crude oil is selling at its most expensive price since 2008, when the commodity hit its record near $147 (for both Brent and WTI).

These prices are a burden for consumers, but an opportunity for investors. So how can investors play this year’s high crude oil prices?

Because it’s impractical to buy physical crude oil for the average person, the closest one can get to direct exposure to the commodity is through futures. If an investor doesn’t want to dabble in futures directly, they can always buy the Brent Crude Oil Fund (NYSEARCA:BNO) or the United States Oil Fund (NYSEARCA:USO), two exchange-traded funds that hold Brent and WTI futures, respectively.

However, exposure to futures comes with its own set of issues. Investors must grapple with the cost of rolling contracts from one month to the next. For WTI, that cost is positive, since the forward curve is in contango. And since Brent is in backwardation, that cost is negative — meaning investors get a boost to their returns from rolling contracts over time.

Brent futures are thus a solid vehicle to bet on rising crude oil prices. But with prices already at $115 and well off their recent lows, there may be a better way to play high oil prices.

In particular, the steep sell-off in global equity markets during August has created opportunities in energy stocks.

Two Stock Picks

Chevron (NYSE:CVX), for example, is trading at a mere 7.5x next year’s forecast earnings. At current prices, the stock also has a very solid 3.2 percent dividend yield, well above the 10-year U.S. government bond yield of around 2.2 percent.

Out of the super-majors, Chevron looks the most attractive. But in an age in which oil resources are becoming ever scarcer, bigger is not necessarily better. For growth, investors may want to look at the stocks of smaller oil companies.

Among these, Continental Resources (NYSE:CLR) stands out. While larger companies struggle to merely hold their production flat, Continental’s output has been surging. Based on the company’s latest guidance, its production may grow 38 percent this year and by more than 20 percent in each of the next three years. At 16x next year’s forecast earnings, the stock is a bargain given those growth rates.

Importantly, Continental is an onshore U.S. oil producer. That’s in contrast to other energy companies that often produce oil in volatile and risky areas, such as the Gulf of Mexico or the Middle East. However, because most of the company’s output comes from the U.S. Midwest, the prices it receives are tied to West Texas Intermediate (WTI), not Brent.

While that’s a negative right now, for investors looking to buy in, that may actually be a positive as it offers more upside opportunity in the event that the differential between WTI and other benchmarks narrows in the future.

More Diversified Plays

Though Chevron and Continental Resources are two solid picks to play high oil prices, buying individual stocks may be too risky for some investors. In that case, the Energy Select Sector SPDR Fund (NYSEARCA:XLE) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP) may be suitable alternatives.

XLE holds all of the energy components of the S&P 500 and is market-cap weighted. It’s unsurprising then that the ETF is biased heavily toward massive integrated oil companies, such as Exxon Mobil (NYSE:XOM), Chevron and the like. In fact, those two companies alone represent 31 percent of the fund.

In contrast, XOP is equal weighted. Integrated oil companies only represent 10 percent of its holdings. Much smaller oil and gas exploration and production companies, such as Chesapeake Energy (NYSE:CHK), SandRidge Energy (NYSE:SD) and a host of others account for 77 percent of the fund. Thus, XOP offers a more diversified portfolio and higher exposure to smaller companies than XLE.

Disclosure: None