Oil Surging, Over $106 Per Barrel On Geo-Political Risk - Ways To Get Exposure To Higher Oil Prices

by: Josh Young

Oil (NYSEARCA:USO) is over $106 per barrel, likely driven up by "geo-political risk" associated with the situation in Egypt, the potential involvement of the US in the Syrian civil war and instability in Turkey. Oil inventories in the US also declined more than expected recently, which could be seasonal but may also be fundamentally driven.

Geo-political risks could further drive up the price of oil and are related to the production and transport of oil. The big risk is that there is spillover of conflict from the current countries to the Gulf, where much of the world's oil exports originate. This could take the form of: 1) some kind of infrastructure-directed terrorism, potentially temporarily destroying or disrupting transportation or production of oil. Or 2) there could be civil wars in other oil producing countries, negatively impacting production and further knocking supply and demand out of balance.

There are different ways to get exposure to rising oil prices. The first is to buy the ETF USO. However, there are issues with commodity ETFs re: contango and backwardation, which can make them difficult to hold and difficult to benefit from long exposure to the commodity. A friend bought USO in 2009 thinking oil prices were too cheap, and only caught a small portion of the repricing of oil from $50 to almost $100 over the following year.

Another way to get exposure is through investing in MLPs. MLPs offer tax advantaged yield (consult your tax advisor) and have benefited from the low interest rate environment. There are mid-stream MLPs, which own pipelines, processing facilities, and gathering systems. The biggest of these is Kinder Morgan (NYSE:KMI) and another popular one is Enterprise Products (NYSE:EPD). And there are up-stream MLPs, which own, develop and acquire producing oil and gas assets. The biggest of these is Linn Energy (LINE) and another popular one is BreightBurn Energy (BBEP). KMI and EPD trade at relatively low yields due to their high historic distribution growth rate. However, higher oil and commodity prices have historically been followed by higher interest rates, which could disproportionately negatively affect mid-stream MLPs, particularly low yielding GPs such as KMI and EPD. LINE and BBEP should benefit from rising oil prices in the long run, even if interest rates rise. But the hedges they have in place limit their economic exposure to rising oil prices in the short run. So in short, neither midstream nor upstream MLPs seem like a great way to get exposure to the rising price of oil, particularly as they have already traded up significantly in the past few years.

Another way to get exposure to rising oil prices is to buy oil services companies, either through the ETF (NYSEARCA:OIH) or through individual stocks such as Halliburton (NYSE:HAL) or Schlumberger (NYSE:SLB). In general oil service activity is correlated with the price of oil and natural gas. However, with the current low price of domestic natural gas, and with the shale oil land rush largely over after the management changes at land-oriented E&Ps like Chesapeake (NYSE:CHK), oil service companies may have trouble sustaining their recent high margins, which may limit further upside to their stocks.

And in my opinion, the best ways to get exposure are small cap, undervalued E&P companies that are highly economically levered to the price of oil. Undervalued small cap companies that I have written about recently include Lucas Energy (LEI) and Gastar (NYSEMKT:GST). Lucas trades at a large discount to its proved reserves and has recently successfully executed a board and management change and eliminated tens of millions of dollars of liabilities. And Gastar is likely to substantially grow its reserves economically on the back of several excellent asset and capital markets deals this year. Historically, LEI has been highly correlated to the price of oil, particularly during steep price spikes or plunges. This relationship has diverged recently, but if the price of oil were to continue to increase, Lucas's fundamentals would dramatically improve and its price could surge again. And Gastar, with its aggressive Hunton and Marcellus development program and low EV/EBITDA valuation compared to its peers, could also trade up significantly.

Of course, it is always difficult to predict the future. I often joke with clients that "my crystal ball is broken". However, it does not hurt to prepare for possible outcomes. And in the current geo-political climate, a production disruption and accompanying rise in the price of oil is becoming more of a likely outcome. This calls for more preparation in case of that eventuality, and potentially repositioning portfolios accordingly.

Disclosure: I am long GST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I may buy or sell any securities mentioned at any time without further notice. I am also short a tiny USO position as a hedge against much larger long oil positions.

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