Blogs & Comment

Oil: Liquid assets

Chaos in the Middle East is giving the price of oil a rise. Some analysts say this could be the start of a long–term surge.

Like a lot of Canadians, Barry Schwartz has been glued to his television set, closely watching the historic uprisings in the Middle East. But while most people are prognosticating on the region’s political future, Schwartz is concerned mostly with one thing: the price of oil. The vice-president of Baskin Financial Services admits he has mixed feelings about what he’s seeing, but is quick to point out that the turmoil has helped his investments. “I feel bad for the people,” says the Toronto-based investment management executive, “but I feel good for owning oil.” Many commodity investors share that sentiment. Since Jan. 25, the first day of Egypt’s uprising, Brent crude oil prices have climbed a whopping 20%. It may be tempting to play the volatility, but it’s a risky game — many investment professionals expect oil prices to fall when the chaos dies down. However, that doesn’t mean investors shouldn’t buy into the commodity; the same experts are fervently bullish on oil’s long-term potential.

Oil will get more valuable in the short term. Many people expect more citizens will rise up across the region, and that’s caused numerous commodity analysts to predict $150-per-barrel oil. The fear is that global supply will be affected by the crisis — while Libya’s output has already declined by a million barrels a day. That, and the fear the unrest could spread into major oil exporting countries like Saudi Arabia or Iran, is sending crude soaring, says Austin Morris, managing partner at New York???based SunGard Global Services.

Some people may want to take advantage of the volatility by buying now in the hopes the conflict will continue to push oil’s price higher. Jeff Rubin, a former CIBC economist and author of Why Your World is About to Get a Whole Lot Smaller, says a spreading crisis, and smaller-than-expected Saudi oil supplies, could inflate prices further. Rubin points to a WikiLeaks cable that says Saudi Arabia pumps out about nine million barrels of oil a day, not the 12.5 million the country claims it’s producing. “The implications of that are huge,” says Rubin. “If Saudi Arabia doesn’t have this spare capacity, then there’s very little to stand on in the way of supply disruptions.” That’s good news for short-term investors looking to make a quick buck, as prices may keep rising for the rest of the year at least. However, before speculating, investors must know what they’re doing, then sell before it’s too late, though that’s a precarious way to invest. “If you see this unrest die down quickly, you’ll see deflation of that price happen quickly,” says Morris.

Long-term demand is rising, in large part, from a growing Asian middle class that’s buying more cars and other goods. Rubin says Chinese oil consumption has doubled in the past decade, and demand is growing by one million barrels a day. According to the economist, demand is already outpacing supply — the world produces 87.5 million barrels of oil per day, but needs 90 million. Despite the numbers, our gas pumps won’t suddenly run dry. Many companies are still finding new oil reserves. The issue, though, is that the commodity is getting more expensive to drill. Rubin points out that conventional oil peaked in 2006. Extracting crude from Canada’s oilsands or the deep sea is costly. Justin Honrath, a research analyst with CPM Group, says that points to falling supply, but it also means prices will have to remain high for oil companies to stay in business. That’s good news for private operations — and the investors who own them — who know how to drill in harsh environments. “It’s the non-state-owned companies that have most of the expertise,” he says.

Investors need to be mindful: when prices get so high that they destroy demand, prices may plummet, like we saw in 2008. The risk to oil prices, says Rubin, isn’t that we’ll suddenly find cheap oil, “it’s that prices will ultimately cause another global recession.” It’s impossible to say at what price that will happen. In 2008, oil climbed to $147 before scaring people off. But as crude climbs, the demand picture will become clearer, and then investors will be able to more accurately tell how company valuations will be affected.

Schwartz suggests starting with a business that’s not in a politically sensitive locale, like in Canada. With Canadian oilsands operations, investors are getting an asset they can buy and hold for years, says Schwartz. When looking for companies, pay attention to the price-to-cash-flow ratio rather than earnings. An oil company typically trades at around five to six times cash flow, but some of the better names, like Canadian Natural Resources, are trading at around eight times. A bit higher than average is fine, says Schwartz, but be wary of anything trading at 10 times cash flow or higher. Investors also have to look at production growth, especially considering global supply and demand imbalances. A company has to show it can produce, and then replace its output, says Schwartz. The latter is key and can be done two ways: by more drilling or acquisition. Also, make sure debt-to-cash-ratio is low — anything over two is a red flag, he says.

Unlike other commodities, investors don’t usually own physical oil. Trading the actual commodity is done either through exchange-traded funds based on futures contracts or the contract itself. Both can be bought and sold like an equity, though Tim Pickering, president of Calgary-based Auspice Capital Advisors, says ETFs are more popular because people are more familiar with the product. ETF or futures investors should be aware that oil prices are based on next month’s price — hence “futures.” People can also buy contracts for a variety of time lengths, including up to a year away. The longer the time horizon, the higher the price, but it’s less volatile than a contract that’s coming due in a few weeks. Pickering says that longer-term investors should purchase longer contracts, while people wanting to play the short-term angle should stick to buying next month’s futures. Investors can buy futures directly through some online brokerages, or via an exchange-traded fund that buys futures contracts. Oil ETFs have different time horizons too, so people should determine their risk tolerance before jumping into this market.

Although the long-term fundamentals look promising, Schwartz says investors shouldn’t put more than 10% of their assets in oil. There’s too much volatility to add any more. Short-term players could buy now and cash out if the price rises, but long-term investors should wait until things settle down. “There’s no better investment than a long-duration oilsand stock,” says Schwartz, “but we like to buy when prices fall, not rise.”

Our picks:

Consider these companies and ETFs if you’re looking to add oil to your portfolio:

Companies

Suncor (TSX: SU)
Calgary-based Suncor should be included in any oil portfolio, says Baskin Financial’s Barry Schwartz. He says the company is expected to deliver double-digit production growth and, because it’s such a prominent player, it’s a steady long-term asset. He also thinks its free cash-flow will increase, which it can use for acquisition targets. Thanks to the Middle East turmoil, the stock price has jumped 20% since Jan. 25.

Canadian Natural Resources Ltd. (TSX: CNQ)
Like Suncor, this Calgary company is expected to significantly increase oilsands production in the coming years. But it also has exposure to natural gas, which Schwartz likes. CNQ owns one of the largest holdings of undeveloped land for natural gas on the continent, and when that market improves, it will be able to bring this untapped inventory online. Since Jan. 25, the stock has climbed 16%.

Talisman (TSX: TLM)
This Calgary-based company is “perennially undervalued,” says Schwartz. Problems with its former CEO and a sale of its oilsands assets made some people nervous. John Manzoni, the boss since 2007, is still figuring out where to position the company. “Is it a natural gas producer? An oil stock? We’re still not sure,” says Schwartz. However, with a strong balance sheet, a desire to acquire and assets in oil and natural gas, it’s only a matter of time until it turns itself around. Its stock price is up 8% since Jan. 25.

Exchange-traded funds

United States Oil Fund (NYSE: USO)
Investors who want to trade crude should look to this ETF, one of the most popular oil ETFs in the world. It mostly holds NYMEX and West Texas Intermediate futures contracts, which roll over every month — though it also has nearly $1.8 billion in cash. It has a 0.45% management expense ratio, $2.1 billion in total net assets and is trading at about $40.

Horizons BetaPro Winter-Term NYMEX Crude Oil (TSX: HUC)
Investors looking for a less volatile oil ETF may want to try this one. Every June, the company buys next year’s December futures contracts for the ETF. That means it rolls over once every 12 months, making the ETF less susceptible to short-term pressures. However, the price has gone up about 10%, to $12.63, since Egypt’s protests began. The fund is based on NYMEX Crude and has a 0.75% management fee.