Hedge Oil Volatility With This Alternative Play

David Fessler
by David Fessler, Energy & Infrastructure Strategist, The Oxford Club Natural Resources Natural Resources
how-to-play-oil-at-50-dollars-per-barrel

For energy investors, the big question now is: “How do I play oil now that it’s selling for half of what it was worth six months ago?”

When oil prices tanked, so did just about every exploration and production (E&P) company in the business. The thought was that no one could make any money with oil at such a low price.

The truth is: Many can.

Forget the Bakken; oil there currently sells at a $25 discount. However, it’s a different story in Texas’ Permian Basin.

Some of the companies operating there have been doing so since the 1930s. Their capital costs are either zero or close to it. They only have operating costs to contend with, which allows them sell oil for a profit at current prices.

And as a result, these companies’ shares are now trading at bargain prices. Some examples of E&Ps operating in the Permian with low capital costs are Pioneer Natural Resources (NYSE:PXD), Apache Corporation (NYSE:APA), Occidental Petroleum Corporation (NYSE:OXY) and Exxon Mobil Corporation (NYSE:XOM).

Some other players in the Permian have higher capital costs to deal with. Many spent billions acquiring Permian acreage and others had to borrow money to do so.

SandRidge Energy Inc. (NYSE:SD), Linn Energy LLC (NASDAQ:LINE), Clayton Williams Energy, Inc. (NYSE:CWEI) and Concho Resources Inc (NYSE:CXO) are examples of companies more highly leveraged than those I listed previously. As you can see, their shares have taken a beating over the last month and have only started to recover. (Data courtesy of Ycharts.)

The problem for individual investors is every E&P company has a different breakeven point depending on a number of factors. Here are the big ones:

  • Amount of debt. Some E&P companies have little or no debt, or can easily service it with existing cash flows.
  • Capital costs. Many companies have owned their acreage for decades and have no royalty obligations. Others paid billions to acquire acreage and owe royalty payments to leaseholders.
  • Cash flow. Established companies have adequate cash flow from oil, natural gas liquids and natural gas to service debt and provide working capital.
  • Working capital. Every E&P company needs sufficient working capital to pay for drilling and completion costs. As the price of oil drops, so do cash flows. This means less working capital available to expand the business.

These variables make sorting the winners from the losers a time-consuming and often speculative process. There’s an easier – and much more reliable – way to play the oil game.

Why I Like Pipeline MLPs

As I mentioned above, I believe crude oil prices are going to experience volatility in the weeks and months ahead. Even well-capitalized E&P companies’ shares could continue to see wide price fluctuations.

That’s why I like pipeline master limited partnerships (MLPs). Even though most got hammered over the last few weeks along with producers, pipeline MLPs are almost completely insulated from the daily swings in crude oil prices.

That’s because most pipeline MLPs have 10- to 20-year-long contracts with their customers. In fact, many of them have waiting lists for customers who need additional capacity.

Also, most pipeline MLPs don’t build a new pipeline until they have at least 75% of the anticipated capacity already sold.

They make excellent investments for taxable accounts, too, since MLPs are required by law to return at least 90% of their profits to unitholders. Distributions (dividends) are actually a return of capital, so they are tax-free.

Below are the total returns of the top ten MLP and MLP funds for the last 12 months. Data is courtesy of MLPdata.com.

As you can see, individual MLPs and funds that hold them handily beat the S&P 500 Index return for the last 12 months. I expect they will do so again in 2015.

The good news is they will do this in spite of whatever oil prices do. Pipeline MLPs are the tollbooth operators of the oil and natural gas transportation highways.

Every growth and income-oriented investor should consider pipeline MLPs for their growth and dividend portfolio. I’ll be recommending them to my Peak Energy Strategist subscribers to add to the ones we already have in our portfolios.

Good Investing,

David Fessler

P.S. If you’re looking for an alternative energy play with huge upside potential, my colleague Sean Brodrick has uncovered an unusual opportunity straight out of science fiction. But strange as this innovation may sound, it could soon fuel more than 10 million automobiles in the United States. Click here to learn more.


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