Using Oil Trusts to Beat Inflation

According to Washington, the official inflation rate is around 4.1%. At this point, I think it's obvious most consumers know this data is wrong. Of course some people accept anything Washington reports (agenda-driven "experts" especially on CNBC and FOX who bring in media hams as cheerleaders to spread the ludicrous propaganda of a strong economy).

You don't need a Ph.D in economics or finance to know that inflation is approaching levels similar to those seen in the 1970s. In fact, those who have been formally trained in these disciplines are more likely to miss what is really going on because they've been programmed to think that fancy math is always superior to common sense. But they often neglect to consider the fact that new standards are continuously being devised to hide the real data - from inflation and unemployment numbers to GDP and poverty statistics.

Methods of Data Manipulation

Understand that most economists are in some way connected to the government. Economists in private industry often sit on Washington committees. Most academic economists too are pressured to accept government methods of data analysis without question, or else they risk losing federal grants, government consulting projects, or being appointed to sit on government committees. Washington has many ways to understate inflation. I'll list just a few:

• Use of core inflation at selected times
• Use of non-core inflation at selected times
• Under weighing essential goods and services like food, energy and healthcare
• Overweighing non-essential goods and services or those with highly variable need so as to neutralize the effects of high inflation of basic necessities
• Use of hedonics
• Changing the assumptions and methods of calculations every year to suit its needs

U.S.-European Central Bank Disconnect

Despite Washington's continued use of accounting gimmicks, the fact is that inflation is around 10% and headed much higher over the next several years. As we all know, inflation damages stock and bond returns. And for consumers, inflation takes its toll due to higher costs of goods and services without commensurate wage increases. Finally, inflation also decreases the buying power of savings. The Federal Reserve is supposed to protect consumers against inflation by raising interest rates in a timely manner. But apparently, they feel otherwise, choosing instead to protect its member-owners – the banks.

Consequently, the printing of over $1.2 trillion (and counting) for a bank bailout has accentuated inflationary effects. In contrast, the European Central Bank has maintained its commitment to protect consumers against inflation because it realizes consumers have no other way to hide from this damaging force. As a result, the dollar continues to weaken against the Euro and virtually every other currency.

The Mission of the European Central Bank 

The European Central Bank and the national central banks together constitute the Eurosystem, the central banking system of the euro area. The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro. We at the European Central Bank are committed to performing all central bank tasks entrusted to us effectively. In so doing, we strive for the highest level of integrity, competence, efficiency and transparency.

I don't know about you, but I'd trade the Federal Reserve Board in for the European Central Bank in a heartbeat. The only problem would be getting Europe to take them. Now I don't want you to think that all of the reserve officials are irresponsible. There are a few regional reserve bankers that have disagreed with Bernanke's and Greenspan's disastrous monetary policies, but unfortunately, they don't call the shots.

Bernanke's dismal response to Greenspan's credit and real estate crisis is now making it more difficult for the European Central Bank to protect consumers. Europe has held off lowering rates to the same extent seen by the Fed. But Bernanke's continued rate cuts have now pressured Europe from raising rates as it should. Most likely, there will be little or no rate hikes in the U.S. before the election. At the very most, a 50-basis point hike. And we all know why – to help secure McCain in office. But it's clear rates need to go up substantially, and soon, or inflation will get much worse.

It is obvious we cannot count on the Federal Reserve to safeguard price stability so investors must take measures to neutralize the effects of inflation. But since Washington continues to understate the inflation data, investing in TIPS (TIPS) currently does not provide a hedge. Relax though. I have a way you might be able to do this. And you might even be able to neutralize the effects of soaring gasoline prices without overpaying for a Toyota Prius. If you believe that the long-term trend in oil prices is up, then you should consider investing in oil trusts. The double-digit dividend yields paid out by many of these securities are in my opinion the best way to hedge inflation.

The Real Meaning of Peak Oil

Those of you who do not believe Peak Oil Theory should first make sure you fully understand it. According to this theory, after a reservoir has been depleted by half of its total volume, the output begins to plateau or remain constant for some unknown period. At some later time (which is unpredictable) the output begins a permanent decline of variable duration (which is also unpredictable) until the remaining quantity of oil is no longer economically feasible to extract with current technology.

Therefore, Peak Oil Theory does not state that the earth is running out of oil per say. It states that the earth is running out of inexpensive oil, otherwise known as conventional oil – the high-grade oil that comes out by drilling on land and requires minimal refinement costs. What this means is that we could have enough total oil (conventional plus non-conventional) say for the next 100 years, but that does not matter. What really matters is how much conventional oil reservoirs remain because this is the lowest cost oil to produce. In other words, Peak Oil is concerned with how much crude we can produce and refine per given day per dollar.

The United States reached its peak oil period in the early 1970s. Ever since that time, we have relied more and more on foreign oil imports. Interestingly, since that time we have also relied more and more on imported goods, while both consumer and federal debt have ballooned. According to many independent (and unbiased) oil experts, the world will soon have reached this peak oil period, causing even more dependence on exploration for non-convention oil. Over the past two decades, new conventional oil finds around the world have been far and few. And what was once thought as large finds have turned out to yield much less than first thought. Throughout this period oil demand has continued to increase. It has especially strengthened over the past few years due to the rapid expansion of Asia.

OPEC has fudged oil reserves data for many years, causing concerns about Peak Oil to remain hidden up until recently. As a result, oil prices have soared. And this has made exploration for non-conventional oil not only more feasible, but mandatory. Consequently, over the past few years, we have become increasingly reliant on more non-conventional oil sources, such as tar and oil sands and deep water drilling. These are considered non-conventional sources because they require large expenditures of money to produce finished petroleum products.

These two variables – increased demand and decreased supplies of conventional oil have been the main forces responsible for record oil prices. Over the past year, oil has also risen due to the inflationary effects from the Federal Reserve, which has weakened the dollar. The dollar-oil link explains many things which you were probably unaware of.

The Secret about Oil

Oil industry giants such as Exxon continue to insist that we have plenty of oil for decades, but then add that more investments are needed for offshore exploration. What they are really saying is that higher oil prices are due to Peak Oil – the decline in conventional oil reservoirs, which is forcing companies to focus on non-conventional oil. They use word games to hide the truth because they realize any possibility of Peak Oil will cause a push for alternative energy, which would threaten their monopoly. OPEC plays the same game. Washington goes along with these fantasies as well for a much bigger reason – the preserve the dollar-oil link.

You see folks, as long as the world is dependent on oil, the dollar remains backed by crude since you can only buy it with the dollar (with one rare exception to be mentioned shortly). This dollar-oil link helps keep the dollar as the universal currency. And because the entire world must use the dollar, you can imagine how that dilutes the inflationary effects of the Fed's printing presses. This is the secret that virtually no one realizes. It is not a conspiracy. It is a fact. And the few in Washington who realize it are never going to admit it.

But consider why it is that America has such good relations with the Saudis. After all, it was President Nixon who negotiated with the Saudi Royal family to demand dollar payments for oil shortly after severing the finally link to the gold standard. Soon after all of OPEC followed suit. In exchange for the dollar-oil link, the Saudi Royal family receives the protection of the U.S. military. This is why the Saudis are rarely criticized by Washington. They have earned a blanket exception for virtually anything they do, including involvement in terrorism and yes, even including holding down oil output.

The Saudis know well that they have a good deal of control over the fate of the U.S. economy. Given the fact that Iran has now created an oil exchange that accepts only the Euro, you should understand why they want nuclear weapons – for protection against a U.S. attack. Severing the dollar-oil link is the easiest way to destroy the U.S. And any committed push to transition the U.S. into alternative energy threatens to destroy the global enslavement by the dollar-oil link. Saddam Hussein tried to sell oil accepting only the Euro in 2000 and we know what happened to him.

Alternative energy will come. But it will come slowly and Washington will make sure of this. Incidentally, I discuss this as one of many critical topics in my book "America's Financial Apocalypse."

Canadian Oil Sands

I'm not going to go into the details of the Canadian oil sands because it's probably old news to most of you. But those who are not that familiar with this huge source of non-conventional oil should do some research. You might want to start by watching the 60 Minutes feature on it about two years ago. Some of you might know of the success of the oil sands from investing in Suncor Energy (SU). For those who are aware of the oil sands but have not yet invested, you need to ask yourself why.

Production and refinement of the oil sands is very expensive, somewhere around $30 to $35 per barrel. Much of the cost is in the very expensive and tedious refinement process, which consumes large amounts of natural gas. That certainly doesn't seem expensive right now, but a few years ago it was. With oil prices more than four times previous levels, billions of dollars have been invested into the oil sands region of Alberta to tap this huge supply of crude. Even China is building a pipeline to Canada.

While Saudi Arabia and other Middle Eastern nations have an average cost per barrel of $1 to $5, we cannot count on OPEC oil when needed. This is especially true with the conflicts in the Middle East. In addition, the world's largest oil field in Saudi Arabia has shown very questionable signs of peaking out, as have many of the world's remaining largest wells. So even if they wanted to increase output, it is doubtful they could meet increased demands for much longer.

The only solution, at least over the next several years, is non-conventional crude. And finding it in Alberta requires very little effort other than scooping it up. The real cost and effort is in the refinement process.

So what does all of this mean? Expensive oil is here to stay for a long time. Higher demand for fossil fuels sparked mainly by Asia have forced oil companies to go for the expensive oil. That alone will serve to keep prices high. Now, with inflation at or above 10%, based on long-term global oil demand versus conventional supply as well as the high costs of non-conventional crude, oil will be high for some time. Therefore, I consider the risk-reward for oil trusts to be quite good. And when you factor in the high inflation rate, the oil sands present an exceptionally lucrative investment opportunity relative to the stock and bond markets. In fact, one of my largest positions is in these oil trusts and has been for some time now. My top two picks are Penn Growth Energy Trust (PGH) and Penn West Energy Trust (PWE).

U.S. Oil Trusts

Unlike the recent birth of their Canadian counterparts, America has its own oil trusts which been around for several years. A few have been around for nearly two decades. These tar deposits produce a somewhat similar type of non-conventional oil. Unlike the Canadian trusts, the U.S. trusts tend to offer a nice combination of high dividend yields along with long-term capital appreciation, although the dividend yields are typically not as high.

Some of the best ones are Sabine Royalty Trust (SBR), Permian Basin (PBT), San Juan Basin Royalty Trust (SJT), and Dorchester Minerals (DMLP). There are also a few gas trusts like Hugoton Royalty Trust (HGT) and Williams Coal Seam Gas Trust (WTU).

In particular, Sabine Royalty Trust has an outstanding track record. You should note its strong increase in dividends as oil prices have soared, combined with its marvelous long-term capital appreciation. This implies that management does not hedge oil prices or does so conservatively. Alternatively, there is a chance that the company could be hedging but its production has soared, although the former possibility is more likely (more on crude price hedging below).

"Isn't Oil Way Ahead of Itself?"

Without a doubt, crude is priced way ahead of itself. And while prices could easily correct downward by 30 to 40% over as little as a two-month period, you should understand a few things before you get spooked:

• Many independent oil experts believe the long-term price trend for oil is headed much higher. So while a price of $140 per barrel might be a couple of years ahead of itself, even with a 40% correction in the near-term, it is very likely that the fair value trading price of oil will be back at this level if not higher over the next two years anyway.

• Many of the oil trusts were trading near or above current levels when oil was below $100 just a few months ago. So if oil does correct, this does not mean the price of these trusts will decline proportionately. As I will discuss below, these companies lock in oil prices so they can provide consistent dividends. Therefore, the trading price of these trusts is not likely to collapse with a large oil correction, as long as management is able to lock in prices.
  However, investors ultimately determine prices of securities so we never know. And price volatility is a reality of investing. What we really need to focus on is the dividend. Therefore we should ask whether a large correction in price will affect the forward dividends. For reasons I will get to shortly, I feel the dividends for at least my favorite two Canadian oil sands trusts (PGH and PWE) are fairly safe.

Risks for Oil Trusts:

• Oil Demand – While America is the clear leader in annual oil consumption, China leads the world in oil growth demand. In other words, China is accelerating its demand for oil more so than any other nation. This is expected to continue for many years, with all of Asia on a similar course. Unlike America, where oil demand will always (until alternative and renewable energy sources are mature) be quite high due its extensive reach within the economy, China's demand is primarily the result of its export trade commerce.
  As corporate America continues to enrich the living standards of China, we will soon see very strong Chinese consumers who, from auto ownership alone, will create huge demands for oil. While it should be quite clear that America faces a continued weak economy for at least the next two to three years, it is unknown to what extent these effects will spill over to the rest of the globe. I would estimate that we will see a global recession. Thus, demand from China is likely to stall at some point. But going forward thereafter, you should expect China's demand for fossil fuels to continue its long-term trajectory.

• Oil Prices – As we have seen, oil demand does not necessarily have a high correlation with oil prices in the short-term. Although there is certainly a correlation, OPEC agendas, military conflicts, speculation and momentum-driven trading often causes huge swings in price. Understand that many Canadian oil trusts typically hedge or lock in oil prices at certain rates so as to ensure consistent dividends for investors.

• Hedging Success and Strategies - When looking at the dividend payouts of these trusts, you might wonder why in the case of Penn Growth for instance, the dividend has remained fairly constant for several months even when oil was well under the $80 mark. Rather than gamble that oil will remain at $140 per barrel, management uses oil futures contracts to lock in what it feels are reasonable prices for oil.
  If you examine some of the previous statements and headlines for Penn Growth, you will see the company reported losses based on futures contracts. The reason was most likely because management bet against oil going up. It did this because it wanted to play it safe. While we can never be sure whether it will continue this strategy, I would expect it to because it is the most prudent way to deliver a consistent earnings stream to investors while minimizing the downside.
  Thus, it would seem reasonable to conclude that even a large correction in crude of say 30% over a one or two month period would not alter the dividend by much. In fact, if traders think otherwise, these trusts could sell off as they have recently, thereby increasing the dividend yield, assuming the future dividends remain fairly consistent.

• Tax Changes – As a way to encourage investment capital into the new Alberta sands region, the oil trusts were exempt from corporate taxation. Since that time, billions of dollars from all over the world have flooded into the region and now the government wants a piece of the action. A couple of years ago the Canadian government announced that the tax treatment for its trusts would be changed starting in 2011. This caused these trusts to sell off in panic. However, I would not anticipate the dividends to be affected by much.
  The good thing is that this news is already known and factored into the price of these trusts. But that does not mean there won't be another correction just before 2011.

• Management – The ability of each management team to run these companies with prudence is always a risk we take as investors.

Ways to Manage Risk

While I plan to continue trading in and out when opportunity arises (to lower risk and cost basis), I won't be bothered if I should get "stuck" in a trade since I will be collecting anywhere from 13 to 18% dividend yields as I have in 2008. The dividend yield of course depends upon two things – the price at which you buy these oil trusts and the amount of dividends that are paid out. Therefore, investors should look to those trusts that have shown a history of consistent or increased payouts. For the later reason, I have as my number one oil trust holding Penn Growth Trust.

Know the Tax Treatment

Prior to investing in these trusts, you should note that the tax treatment for the Canadian oil sands is not the same as some of the U.S. oil trusts like Sabine Royalty Trust, Permian Basin, San Juan Basin Royalty Trust, and Dorchester Minerals. They are either structured as limited partnerships or some other form of trusts different from the Canadian trusts.

For some, the U.S. oil trusts will be preferred. The only problem I have with new positions in these trusts is that I am not sure how much remaining oil they have. Some of you who have held these trusts for many years might have a better level of comfort and certainly a very low cost basis, which offers lower risk for further investment. Regardless, prior to investing in any of these oil trusts, you should ask your tax adviser how they are treated. If you do decide to gain some exposure, don't rush in all at once. But now is certainly a great entry point, as many of the Canadian trusts are approaching year lows.

Risk Comparison

When we compare the risk of oil trusts, we should look at asset classes with similar rates of return. The first type of asset class that comes to mind is REITs. After all that has happened to the real estate market, I do not think I need to discuss the risk level here.

On average, the Canadian oil trusts I have mentioned are yielding around 14% annually. The only other major asset class that even comes close to this is small cap stocks. However, you should note that even small caps only return around 11% on average, and that is over a long period, such as 20 or 30 years. As well, the volatility is higher and there are some small caps that go bankrupt. I certainly wouldn't want to be in small caps during this market.

Even if you are willing to assume the risk of small caps given current market conditions, you would most likely need to actively trade these stocks in order to secure any chance of annual double digit returns over say a 5-year horizon. Otherwise, you could end up flat or even down over that period. In contrast, the oil sands pay monthly dividends. That's money that comes every month; money that can help neutralize the declining purchasing power of the dollar.

In conclusion, whether you want to go Canadian or American, oil trusts offer an excellent solution to counter the effects of high inflation. And during this period of economic uncertainty, perhaps one of the few things we can be certain of is that oil will remain high for many years.

Remember, before you can justify investing in oil trusts, the oil story is something you have to fully believe in because these securities are volatile. While trading opportunities are definitely available, you should be willing to hold them for several years. In fact, at current prices and assuming historical dividend payouts to continue, your cost basis (before taxes) would approach zero if you bought and held Penn Growth or Penn West over the next eight years.