Using Oil & Gas Trusts to Beat Inflation

Using Oil & Gas Trusts to Beat Inflation

by Mike Stathis, Managing Principle, Apex Venture Advisors

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, especially the agenda-driven “experts” on television 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.

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.

Important Considerations

14% returns are much better than the market’s historical average of around 8%. So what’s the catch? Well, we obviously need to consider the risks before we make any decisions. In the end, you should understand your risk tolerance and investment horizon. After considering the risks, you will be able to determine a risk-reward profile for these investments. This is the general method to determine suitability for all investments. Let’s take a look at some of the more important variables to consider.

Oil Demand

Oil demand is obviously a very important consideration one must make. Some of the questions you might pose are:

Is demand growth accelerating?

What are the reasons for this acceleration and what are the risks for it to end?
What impact will alternative energy have on oil demand and when might a real effect be seen?

While America is the clear leader in annual oil consumption, China leads the world in oil growth demand. In other words, China is accelerating is 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.

While there is certainly much noise over alternative energy, the fact is that it will take many years before it makes a dent in the global oil demand. And it will come gradually, allowing OPEC and non-OPEC producing nations to gradually adjust output and resources so that they are able to control demand-supply and thus pricing. Even when alternative energy becomes highly competitive with oil and other fossil fuels (which might not be before 2020), keep in mind that we will always need crude for basic materials. It is a building block for many products.

Oil Prices

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. 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.

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 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.

Finally, 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. They did this because they wanted to play it safe. While we can never be sure whether they will continue this strategy, I would expect them 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 effected 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.

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.


Conclusions

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 Baytex, Paramount, Bonavista, Arc, Advantage, Crescent Point, Enerplus, Freehold or Penn West over the next eight years.