$125 Oil Not Sustainable for the Time Being

These are the types of things you write and feel stupid about a year later, but I am going to go on the record and say it. Oil is at $125 per barrel and has been as high as $135. Even worse, talk has abounded about it heading to $200 in the next year. Anything is possible and ultimately, yes, oil will get to $200 per barrel. However, before it starts the upward climb to that level, the price of oil is going to level out around $80-$90 per barrel and stay there for a while. As for $200, again, it will happen, but maybe in 5-7 years – and definitely not in the next couple of months.

I am not a commodity trader. I am not very knowledgeable about oil marketplace dynamics. I do not own any oil stocks. And I have no political agenda to force these prices down. Certainly, if we do something bonehead like go to war with Iran, which could happen, just throw this article away. But, all things normal, oil is due for a big correction and to cease its gigantic upward swing that has occurred over the past 10 years.

I am not going to cite graphs about how the price of oil is spiking just as we are seeing a significant decline of gas consumption like one we have not seen for a while. I am not going to cite the elements of the U.S. recession or even a global economic slowdown that threatens to seriously damper demand for petroleum. I am just going to look at some very basic, almost superstitious items that indicate to me this thing is about to blow up.

1. Stupid Headlines

When oil touched $129, a news item had the headline: "Oil closes at $129 – Going to $130." Are you serious? That is just the worst headline ever. It reminds me of the Internet stock days of 2001 where people were posting these insane price targets on companies like Yahoo, Qualcomm, and others. The price targets were basically suggesting that the stocks would go up forever and ever. Impossible and many investors got caught holding the bag.

Remember this headline about Qualcomm (QCOM) in December, 1999? Qualcomm jumps on $1,000 price target. The stock was basically at $700 per share, split adjusted, back then. Where is it today? $392 split adjusted. As for $1,000, it never came close.

With the stupid headline of oil hitting $129 and then saying it was going to $130 and nothing was stopping it, well, that is just irrational stupidity. This is where the average retail investor finally gives in and buys oil stocks to ease the pain at the pump – just to get massacred. Of course, oil did breach $130, but the stupidity was further amplified when oil was at $135 and the entire Fast Money crew suggested betting the ranch on going to $140. It never hit $140. It may, of course, but when the entire world thinks it is going up, it may be time to look the other way.

2. Yields Getting High

If you own a stock that pays a dividend, it has a dividend yield. If a stock pays $1 in dividends per year and is at $40 per share, that stock yields 2.5%. I will let the math majors take over. It is akin to the interest rate you receive on your savings or money market account. Pfizer (PFE), for instance, is at 6.6%; Merck is at 3.9% (MRK).

If you want crazy yields, turn to the BP Prudhoe Bay Royalty Trust (BPT) that will earn you 11.2%, Penn West Energy Trust (PWE) that is yielding 13.2%, or Permian Basin Royalty Trust (PBT) at 10.1%. That means, assuming the dividends held steady, you would be earnings a near 'guaranteed' 11.2%, 13.2%, and 10.1%, respectively, on your money.

That sounds easy. You can borrow money on margin for 6%-7% or even run up your 0% intro rate credit card and just earn the difference. Yields are great, but the reality is, investors have always been told to be wary of high dividend yields. The trusts, of course, are supposed to pay out a higher rate of return. They are high risk investments as the amount of their payout is totally related to the price of oil – the higher the price of oil, the higher the payout.

For instance, BPT used to be under $10 per unit back when oil was at $10 per barrel; it has come close to $100 per unit. There is no question that BPT has been good to patient oil investors, but the party may be over. Take a look at the 5 year and 10 year average dividend yields of these trusts and others. For instance, BPT is at 11.2%, but the past 5 years, is at 9.8%. PBT sports a 5-year average yield of 8.2%. If you go back 10 years, you will find these average yields are even lower. What does this mean?

If BPT historically at an 8%-9% yield, how come the units are not trading at $120 (they are currently at $95)? You can see a similar relationship back in the late 1990s when BPT was sporting double digit yields, but everyone thought the price of oil was going to keep dropping to nothing and the price of the units were overly depressed. Nobody wanted oil and the units would pay you handsomely to own them. Now, everyone wants oil and you are getting paid handsomely at the same rate to own them? It just does not make sense. In short, BPT, from a historical standpoint should be at $120, but it is at $95 and the secret is out.

My point is that the price of the units may remain the same, but as the price oil falls, the distributions will decline. For instance, if oil were to hit $200 per barrel in a year, you would estimate the BPT yield to be over 17%!!! Doesn't everyone know it is going to $200? Apparently not because the units are trading as if the distributions should be more in line with $80 oil. At $80 oil, at current levels, BPT would be yielding roughly 8.3%, far more in line with historical numbers.

Now, this is not exactly apples to apples and there are many variables, but it leads me to wonder if the big buying in these oil derivative positions is done. If that is the case, it could suggest that big chunks of money think the oil price party is over.

3. The Rich Are Complaining

When people with incomes in the top 3% of the population are complaining about gas prices, you must take notice. Certainly, nobody wants to spend money, but regardless of prices, there is always a group of people that do not complain because it really does not have a material impact on their finances. When people earning $100,000+ per year are genuinely complaining about how high gas prices is effecting their home life and decision making, that is when the impacts have literally filtered across the board. That is, there is no place the pain of the oil prices have left untouched.

Over the long term, the price of oil will likely continue to rise, but historically, it has risen somewhat in line with what people make and earn. If you were making twice as much, paying double for gas would not be such a big deal. But when your income is stagnant and prices have soared, there are problems. With the high oil prices effecting everyone, further rises in prices are simply unjustified from a marketplace standpoint.

4. The Chrysler Guarantee

Chrysler is offering a three year guarantee of $2.99 per gallon on gasoline. That is, you will pay only $2.99 per gallon of gas for the first 12,000 miles each of the next three years.

Of course, there are restrictions, but let's just do the math. At 25 miles per gallon and 12,000 miles, that is 480 gallons per year. If gas prices are at $4 per gallon and some think they will go to $5, well, that is an extra $500-$1000 per year or $1,500-$3,000 over the three year tenure that Chrysler is on the hook for. Do you really think Chrysler can afford $3,000 per car of just giving money away? Marketing dollars and rebates are one thing – buying something high and selling for less, well, makes no business sense. It is not known that this marketing ploy will work, but it could be a double dip for Chrysler.

If it works, Chrysler sells a bunch of new cars and if gas prices go down to $3 per gallon, there will be far less exposure than $3,000. Chrysler may even count on people not caring about gas at $2.99 if it is at $3.25. If gas goes to $2.75, well, then the marketing ploy is worthless to the consumer. I'd personally rather have $3,000 off my vehicle purchase. Perhaps gas and oil prices may not retreat too far from $4, but gas prices reaching $5-6 per gallon and staying there and causing Chrysler a world of hurt, that is even more unlikely.

I am not really sure what is going to happen – nobody really knows. Prices may remain high during the summer months which is the 'driving' season and with people freaking out about hurricanes. But, all of the intangible pieces for a huge collapse in oil prices are coming together. Hopefully, it will provide some financial relief for consumers and our wallets and frankly, just bring things back to some level of normalcy.

Disclosure: None

Comments

[redbaron]

The oil analyst I follow, i.e., Kurt Wulf, at mcdep.com, projects that some of the oil/gas income trusts you mention here, have a very long life that numbers into several decades in the future. For instance, on Canadian Oil Sands Trusts he projects 70 years of income without a substantial decline in production. PWE also has a very long life projection, as does another, HGT (Hugotan Royalty Trust). So your suggestion that the yield will drop as the production declines, doesn't fit Mr. Wulff's models.

As a result, you actually make a very good case for investing in these trusts, since your basic premise that production will decline, may well be wrong.

In times like these, one must decide which 'expert' to listen to. Kurt Wulff has been 'spot-on right' about oil prices and further, his selections for income have also been spot-on. I am going to follow his advice, and not someone who admits to having no background or knowledge on the subject.

I should also point out that there well could be another way for the yield to decline on the energy income trusts, both the ones you mention above, and the ones you don't mention..........and that would be for the stock price of the trust(s) to go up, and bring the yield more into line with quoted interest rates. I think that this is the more likely route, and makes these trusts even more attractive as an investment.

IMHO

2008 Jun 08 08:58 AM

[CarltonMeyer]

Most people cite supply and demand when projecting prices, not chartism. If this is a bubble, why is the P/E of oil stocks the lowest in the market?

Anyway, you actually argue that the high-dividend oil trusts are undervalued because they have not kept up with the price of oil. Do a chart at Yahoo to see this, use OIL for the price of oil.

You forget that current dividend yields are based on the trailing price of oil, i.e. $80 a barrel over the past year. If oil falls back to this level, they are now fairly priced. If not, their yield will move up further, drawing more interest, thus pushing up the stock price.

In your worst case example, you worry that their dividend may fall to 8%. Given that stocks pay less than 2%, I will not lose any sleep.

2008 Jun 08 10:29 AM

[GMiki1]

If you don't really know the industry, you're just going on your opinion. Everyone has an opinion. My opinion is based on listening to Jim Puplava every week and the oil analysts such as Zapata George. I bought PWE after George mentioned it.

Ordinarily you might rely on the charts--if supply were adequate. But it's not.

2008 Jun 08 10:37 AM

[Greg Pinelli]

Brilliant article! You manage,in a mere few overstuffed, clumsy pages, to entirely misunderstand, oil, Canadian oil/gas trusts, and just about any other issue you touch on. My burning question is...does anyone at Alpha proofread this stuff? Or bother to vet its propagators? Or do they just look at these sappy pictures and figure..oh well???
PWE, for instance, has been lashed weakly by perennial lightweight David Bui..even though..wink..wink..he... a PWE investor! It's Trust structure..as well as Linn Energies PTP (Publically traded partnership) structure allow then to pass thru what would otherwise be huge hoarded cash flows to investors. Bith have very strong sage haven resource bases..but why bother with a few facts when you can just throw some ill informed opinions around! Have a nice day.

2008 Jun 08 10:51 AM

[Kingfish]

I think that you are a trend follower and your thought process is right on.

Having experienced the oil industry of the late 70's and early 80's, I have seen the business go from boom to bust. I am a small investor (100 share range) and try to buy low and sell higher. I have invested in Williams when it was 3 (2003) and sold in the low 20 (2006), I now live in a house instead of renting. My biggest problem is determining the whens, when to buy, when to sell.

I also follow the oil shipping companies. I have found them to be very cyclical in nature, low in the summer time and high in the winter this normally the same thing with oil and gas trust.

So the question is do you have any insight to when the drop will happen?

2008 Jun 08 11:27 AM

[UripaDs]

This article is amateurish and totally whacked out when discussing BPT and PWE. These stocks both have limited oil and gas in the ground, so the 10% or 13% yield is not really a dividend as much as prehaps half dividend and half depletion allowance. Because BPT has significantly depleted its reserves since it was trading at $10, that is why its stock price has not kept up with the price of oil in a strictly linear fashion. USA royalty trusts like BPT cannot retain earnings to purchase more reserves. Canadian royalty trusts can and do retain some of their earnings, 20-50% typically, to purchase more reserved at opportune times, so while they may have 10 years of oil left in the ground, ten years from now they may still have 6 years of oil left in the ground due to acquired properties.

2008 Jun 08 01:13 PM

[OJO Zafado]

"The future belongs to the young". I suppose that applies to the young fresh faced as well. Based on the portrait published with this long winded drivel, I suppose we will count you as the young. Not out of High school perhaps when Canroys were crushed by the Canadian government proposing a two separate share class system. One for Canadians and one for aliens. That crushing killed the Canadian shareholders and the plan was scrapped. Then the Halloween massacre... Canroys are subject to great volatility due to the various and MANY risk factors they carry. The greater the risk the greater the reward. Odd that I used the 0% credit card scam back when it was zero percent. I bought AAV with the cash that Discover gave me. Back then there was no 3% transfer fee and the 0% lasted a long time. I am still getting the 0% from Discover 2 years later. It is a sweet deal margin account alright! Too many people figured out that if you ever charged anything on the credit card your 0% was out the window. Now 0% is available for less than 6 months and when calculating the 3% transfer fee, that is then 6% APR. !No Mas! That hedge is obsolete. Still you can do quite nicely if you get some good short term gains booked early in the year. As margin interest is deductible against short term gains, then you are left collecting the tax advantaged dividends at the15% tax rate. Effectively converting fully taxed ST gains into 15% taxable income. As for the poor Joe capitualating and buying this oil market I am right in there having bought the UHN and IEO after my +$600 heating oil bill came in at $4/Gal, 4 weeks ago. I am ahead over $100 in the positions and hope I do lose money as that would mean oil deliveries for next winter will not take away a Florida or Hawaii vacation. It must be the time change as no one in Hawaii can tell you whether or not the ground hog saw his shadow. It is not an acknowleged event! Wouldn't "boneheaded" worked better grammatically than "bonehead'? Why not do research and learn what you are talking about before writing an article? Why didn't you warn us that met coal was going alot higher when FDG was at $20? Maybe you were still in college playing rugby then, EH?

2008 Jun 08 01:51 PM

[tchannon]

As author of the article, I again claim no expertise in this arena - I just go by what I see. If I am wrong, well, I am just wrong as all have been wrong before - everyone from neophytes to sophisticated experts. If I am right, the same thing - and either way, nobody really cares.

My point is when the entire world is acting and thinking that the price of oil will go up forever and ever, well, maybe it is time to quantify the downside. Extreme peaks and troughs in a marketplace are typically characterized by irrational behavior and activity (my above article may certainly qualify) - and the subsequent collapse is often just as chaotic and irrational and often cannot be explained with logical thought.

I don't have the sophisticated data to back up the above - I will let the experts fill in the blanks. If I am wrong in my base assessment, then I am wrong, and best of luck to the oil longs. But if I am right, I take no credit - I just know I won't be holding the bag.

2008 Jun 08 01:51 PM

[sf94127]

T. Boone Pickens offered a very simple analysis: supply is 86 million barrels/day and supply is 85 million barrels/day.

My opinion:As long as demand exceeds supply, futures traders can put te price higher, what is there to stop them? Once supply is greater then demand and the futures traders want to go short in mass then the price will drop.

2008 Jun 08 02:04 PM

[redbaron]

No where in your piece, do you mention increased Global Oil Consumption, or increased Global Oil Demand. Your premise seems to be that at some point there will be a top in oil price, and I suppose if we all live long enough, that will be true. When, is the question, and your suggestion that now is the top, due to the factors mentioned, has been completely shot down. If it in fact, occurs any time soon, it will not be because of anything you have mentioned in the article. What has Chryslers offer to buyers to do with anything?

SF94127, I am thinking that you mean to quote T. Boone as saying Demand is 86 mbpd, and Supply is 85. I would never argue with him........he knows more about this subject than all of the rest of these writers combined, and he is smart enough to not tip his hand.

Hopefully, future articles here will be a little more researched, or reasoned that this article (for lack of a more acceptable term). I agree with Georealist..........Do... anybody preview this stuff before it is posted? Surely someone on the bear side can do better than this. And if not, oil/gas is surely going higher, as there seems to be no logical reason for it act differently.

2008 Jun 08 03:57 PM

[Zeek the Dog]

I've seen and heard this movie before.............. when oil was at $40. Remember? Oh it will never last! It's a bubble! The era of finding and recovering cheap oil is coming to an end my friends. To those who believe using oil is killing the Earth........well the high prices should fix that. Please don't even think about complaining. And to those who think oil should drop in price, simply because its never been so high, where will your demand destruction be if the price comes down? Tell 2.5 billion people that the US would like cheaper oil price, therefore they need to cut back a little. I don't think that's gonna fly. If the Europeans can fork over $8.00 per gallon and survive, so can every one else. And to those who place the blame on speculators........ple... remember we are investors. We believe there is value here, there is room for investments in energy to grow, there is something actually produced at the end of the day, a mile driven, a piece of steal made, a light bulb shining. That's the difference between investing in energy vs the dotcoms. What have the dotcoms ever really produced?
Zeeko

2008 Jun 08 04:34 PM

[inthewings]

Actually, Pickens said demand is at 87mm and supply is at 85mm.

2008 Jun 08 04:58 PM

[relaplan]

While oil price decline as a result of demand distruction is a possibility, the author must also consider reasons why the near term price(6months) might continue to increase. They are: (1) supply decline, many major oil fields around the world are experiencing significant production declines. (2) value of $US, the poor condition of the US fiscal balance sheet might cause the $US to continue to decline, causing $/bbl to increase far more in the US. (3) oil demand is likely to continue to grow in world's developing countries. With their strong currencies they can better afford $US priced oil.

2008 Jun 08 05:11 PM

[2-cents]

Look at the author's bio and judge for yourself. What type of business he's in. Selling investment advices. That's for me is equivalent to real-estate agents.

2008 Jun 08 05:30 PM

[ggbbppl]

let not forget about our northern brothers they have a hugh reserve in oil and gas and these companies that produce oil and gas prices are very very low. it is time to buy. oil and gas take billion year to make by mother earth ,now is running low. buy erf, pvx, hte,pds, and pgh. some of these compaines has their own refinieries.prices are low.

2008 Jun 08 06:50 PM

[Marshall Sohne]

Im in Real Estate Ive been in it for few cycles the bubble aspect of the business (or at least the prices) is kind of like musical chairs you play the game but in the back of your mind you know the music will stop and you hope you end up with a chair. Ive done ok and so far Ive been lucky. Energy especially oil and gas has been relatively cheap for a long time. I guess we as country ignored or at least sat by and failed to play heads up to the changing world. Cheap energy thats yesterdays news. Going forward at least for the near to middle term energy is going up. It will go up to what ever price balances supply and demand. This is energy , plenty of oil and gas it just a question of price. Oil can be made synthetically out of coal or natural gas but we are no longer going to be just reaping the low hung fruit. The prices as we know are determined at the margins. The prices are also going to be determined by worldwide demand and competition. And while it is clear that the high prices are causing some demand destruction in our country. There are many developing countries where the dynamics of their economies are causing more demand so that net demand overall may not be abating. Supply has at least flattened oil pools deplete overtime the low hung fruit the easy oil supply is depleting. Deep oil, tar sands, shale, coal gassification require more effort , more energy, higher costs. What price should oil be ? What price should water be ? What price for food? I dont believe new supply will come on line for less than whatever it costs to produce thats just how it is ? If we are short supply than it gets allocated by who ever bids the highest. Thats where we are right now. So over time we get new supply to satisfy demand assuming higher prices create incentives at the same time we have demand destruction to the extent needed. Ok Oil is more expensive than it has been. Is it a bubble ??? we will see I am no expert but where is all the ready supply hiding ? I see the demand destruction but worldwide i guess these high prices have some more work to do ? Hopefully all the demand destruction wont just be pain but will guide us to alternate life styles and technologies. They say necessity is the mother of invention. For disclosure purposes I own a bunch of PWE both for the yield and I would have thought It would have moved much higher with oil and gas prices at this level. I have no expertise with stocks but it seems that PWE has the cash flow, controls some low hanging fruit that I expect to go up in value and I am willing to take the risking of receiving their double digit yield while watching the worlds economies clean up the mess we are in. I also read David Bui comments on Seeking Alpha I dont think he is bashing PWE. His comments appear well thought out and fair. If it is disturbing than maybe one should seek the answers to his questions. Im still holding on to my shares I think the fundamentals and pricing over power nuances raised by his questions. But Id like to hear the answers in any event. Transparency is important.

2008 Jun 08 07:34 PM

[burncapital]

You say your no expert but give a fairly confident price target of $80 - $90 in paragraph 1. In any case, PWE has been paying out $0.34 cents per unit since early 2006 when oil was what, $40 - $60 maybe.

So how do you reconcile the implication of PWE reducing payout when it was sustained at $40 - $60 versus your pretty resolute $80 - $90 target?

2008 Jun 08 07:40 PM

[TA]

Don't let the speculator commentors and their anger at you exposing them bother you.

You make some great points on top indicators - I would add to your list what another seekingalpha author brought up - GM and Ford just cried uncle and dumped their SUV and truck production

2008 Jun 08 10:20 PM

[bertyang]

Every car Chrysler sells under the 3-year gas guarantee will drive UP the price of gas! You are right, Chrysler cannot afford to make a 3-year guarantee if oil goes to $200 barrel....UNLESS they're also buying futures contracts, guaranteeing the delivery of oil in the future at a set price.

And unless Chrysler has no risk management department, they are buying the oil futures and driving up the price of oil (making the deal appear even more attractive). So Chrysler's promise makes it seem even MORE likely that we'll see $200/barrel oil soon.

I wouldn't be surprised if other car dealers also soon buy TONS and TONS of oil futures, driving up the price of oil, then making gas price guarantees. The car manufacturers have the money and knowledge to make these guarantees that average American's can't (no money) or don't know how (future contracts, ETF's).

2008 Jun 08 10:45 PM

[Ron H]

Ever heard of Boone Pickens? If you are not an investor, don't know oil, not an economist, what the hell is your authority on oil prices?

2008 Jun 08 11:27 PM