Last week we looked at how oil prices seem to keep on ratcheting upwards. And I argued that we are just going to have to get used this.
OPEC are going to do their best to keep oil prices high and steady. And the ugly truth is that most of the cheap oil is gone. So it could be that in ten years’ time, we’ll regard $100 a barrel as cheap!
It makes sense then for us to start stocking up on black gold. And it’s not a bad time to do it. With oil stocks still suffering from the fallout of the Deepwater Horizon disaster there are some great ways to do that right now. You just have to avoid the pitfalls.
The wrong way to buy oil
I’m a big fan of ETFs, they’re generally a great, low-cost way to get exposure to indexes of shares and other investments. But when it comes to commodities, you’ve got to tread very carefully.
That’s because many commodity ETFs get exposure through futures contracts. Here’s how it works.
They’ll buy a contract for oil with a delivery date in the future; say next December. Now because the ETF doesn’t want to take physical delivery, they’ll sell the contract just before it expires.
With the proceeds they buy a new contract, with delivery for the following June. But there’s a problem. Generally, future contracts are more expensive than expiring ones; a phenomenon called contango.
The future contract isn’t always dearer, but it usually is. It reflects financing costs, storage costs and the extent to which traders are bullish on the market. Incidentally, contango is even higher now that the authorities are dumping oil onto the market from strategic reserves. The market assumes that this dumping will only cause a temporary reprieve for rising prices.
Selling a cheap contract and buying an expensive one is obviously bad business. Even if the oil price moves up, the ETF can move down! This is a disaster area. In my opinion the banks shouldn’t be allowed to market these sorts of things as ETFs.
Most investors assume that an ETF will track the price of whatever it’s advertising. This sort of thing sullies the whole ETF market.
Let’s look at a better way to play rising oil.
An oil play that yields up to 6.3%
Oil isn’t like gold. You can’t just buy a few barrels and tuck them away in a drawer. And we’ve just looked at the problems of getting exposure through the futures markets.
The oil majors are an obvious way of getting exposure, but they’re not without their problems. The risks of deep-sea drilling and the increasing costs of getting the stuff out of the ground have been well flagged. And as one Right Side reader pointed out, you can’t rule out further windfall taxes.
I hold some oil majors, but recently I’ve been looking into another way of playing rising oil. What I’ve got now is a much better way of getting pure oil exposure.
And that’s through royalty trusts. These are publicly traded companies that buy oil fields and then hand them over to oil companies to do the rest. In return for using the trust’s asset, the production company pays a royalty to the trust.
If the price of oil goes up, the royalties get bigger (and vice versa). So it’s little wonder the trust prices tend to follow the oil price.
For tax reasons, the trust has to pay out a large proportion of the royalties it receives as a dividend to investors. At the moment the trusts I’ve been looking at are yielding between 5.7% and 6.3%.
Now I ask you. Why on earth would you buy an oil ETF with the potential to lose money even if oil goes up, when you can buy a trust paying out a handsome dividend?
Here’s how to get in
The big trusts are listed in the US and Canada. Unfortunately the Canadian trusts lost their special tax status (double tax relief) this year and have suffered for that.
But I’ve looked at a few US trusts. The three largest US energy royalty trusts are San Juan Royalty Trust, (NYSE: SJT), Hugoton Royalty Trust, (NYSE: HGT) and Permian Basin Royalty Trust, (NYSE: PBT)
| Price | Yield | Mkt Cap | |
|---|---|---|---|
| San Juan Royalty Trust | $24.4 | 5.7% | $1,136m |
| Hugoton Royalty Trust | $22.8 | 5.9% | $913m |
| Permian Basin Royalty Trust | $21.7 | 6.3% | $1,012m |
Most brokers will deal New York listed stocks. Of course, your broker will have to convert your funds to dollars which introduces a currency risk. But then again, if you’re investing in oil, you’re already into a dollar asset.
The three companies I mentioned are massive and are well researched. I expect the yields on offer reflect the assets the trusts own and the earnings they’re making. I’m not going to say one’s better than the other – I prefer a mix of all three.
But there are a few general things you should be aware of:
The oil assets are a finite resource. At some point the fields will run dry, so you can’t assume your royalties continue in perpetuity.
And though I’ve said that the share prices tend to follow oil prices, there’s no guarantee. If the stock market tanks, then I’d expect the shares to take a hit too. And though the trusts hold mainly oil assets, they’re also into gas and some other commodities.
I don’t think that’s a bad thing. But it’s another reason why the share price isn’t a proxy for oil.
Given the decent yields and the innate play on oil, these royalty trusts could be great investments to tuck away as part of a long-term savings plan.
Unlike so many paper-based investments, at least these stocks are backed by something fundamentally useful. Property with black gold underneath it.
Sounds good to me.
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