Here’s the Right Way to Play Rising Oil Prices – Part One

By TradeSmith Editorial Staff

Remember about a year ago when oil crashed? No one wanted oil. Supply was abundant with no demand.

Fast forward just a year and oil is now in a raging bull market.

There are fund managers and oil traders with decades of experience buying and selling crude around the globe right now.

They’re trading barrels across offices in Houston, London, Dubai, and Geneva.

They’re moving millions, if not billions, of dollars on single trades.

They’re so attuned to the global crude market, they likely know the names of individual pipelines in countries like Saudi Arabia, Belarus, Mexico, or even Thailand.

And they can even tell you the length and storage capacity of huge oil tankers like the Seawise Giant, Bellamya, or Batillus.

Well… chances are… you’re not one of those traders.

And neither am I.

But I’ve learned there are right ways to trade the rising price of oil and wrong ways.

So, what do you say we discuss these options instead of that new pipeline in Angola?

Why Are Oil Prices Rising?

On Tuesday, global oil prices rallied once again.

The price of West Texas Intermediate (WTI) crude – the benchmark for North America – rose 2.5% and nearly closed at $68.00.

Meanwhile, Brent crude (the global benchmark) increased by nearly 2% and closed at $70.69. This price was a two-year high for crude.

WTI crude is typically sourced from landlocked North American oil fields, while Brent comes from the North Sea above central Europe. WTI crude is “sweeter” than Brent, but I’m not talking about sugar. The term “sweeter” means that it contains less sulfur, making it more ideal for refining into products like gasoline, plastics, and diesel fuel. There are many other factors that we’ll consider in future Daily issues.

For now, let’s focus on a few factors that drove oil prices higher in recent weeks.

First, the summer driving season is well underway. This seasonal factor is important because oil demand is typically higher in summer travel seasons than during the winter (with the exception of last summer’s COVID-19 slump, of course).

In addition, more and more states and countries are reopening.

Demand for oil is back on the mend, and the more robust the recovery, the faster we’ll see crude consumption increase. There are other important demand metrics in oil such as economic growth, changing demographics, and commercial and personal transportation.

But think back to your Economics 101 class.

Demand is only one side of the global crude market equation.

Supply is the other critical component.

Globally, supplies have been intentionally constrained by major market participants over the last year. After all, if supplies are very high at a time when demand is low (say in the middle of a pandemic), that’s bad for oil producers who might end up selling their product at a loss to their production costs.

There are a lot of politics involved in the global crude market, and there has been an interesting battle between U.S. producers and their foreign competitors over the last decade.

That’s also a subject for a different time.

What matters the most in recent days is a statement by OPEC that could keep crude prices moving higher in the coming weeks.

Why OPEC Matters

OPEC is a global energy cartel that controls the production of crude across its 13 member nations that include Iraq, Saudi Arabia, Venezuela, and Libya.

The cartel has also aligned its interests with Russia to work together to keep supply constrained around the world in order to help support higher crude prices.

Think about what they are doing. By working together to limit the amount of supply that each pumps, they artificially limit crude on the global market.

Why do they matter? Because they constrain the production for their member nations. OPEC accounts for nearly 40% of global oil production. In 2018, these countries also sat on top of 79.4% of global proven oil reserves.

Every few months, these nations’ oil ministers gather to discuss the best course of action to elevate prices, manage production output, and predict global demand.

In the face of COVID and the ensuing plunge in demand – OPEC and oil-producing allies like Russia (which is called OPEC+) decided to cut production by 9.7 million barrels last year.

As demand slowly improved, they eased those cuts by the start of 2021 to 7.2 million barrels. Now they aim to bring another 2.1 million barrels back online.

While they will still be down about 5.8 million barrels compared to the start of the crisis, the elevated price points will allow the member nations to make money while they wait for pre-pandemic demand to return.

Despite those cuts, oil prices are up about 30% since the start of the year.

However, some analysts (including our own Chief Research Officer, Justice Clark Litle) are projecting that oil will continue to rise.

Goldman Sachs said last week that it expects Brent crude to hit $80 later this year. In fact, the bank believes crude prices will rise despite efforts by OPEC to bring Iran’s crude exports back online. Iran has been unable to bring crude to markets due to sanctions related to its nuclear weapons program.

President Joe Biden aims to reinstate a deal between the U.S. and Iran that was torn up by the previous administration.

Iranian crude exports, however, are subject to management by OPEC. Though Iran may soon aim to bring 2.5 million barrels back online to the global market, OPEC will likely ensure that these exports deliver in a structured manner and don’t impact the global supply-and-demand balance.

If crude prices are set to rise, there are two ways to play an uptick in prices that I’d like to highlight.

Here’s How to Play Rising Oil Prices

If we’re going to speculate on oil prices remaining higher for longer, there are a few smart ways to invest. And a few ways you should avoid.

Professional traders and hedge funds are the dominant players in the oil futures markets. Unless you understand how contracts and leverage work, steer clear of exchange-traded funds (ETFs) linked to the oil price and consider these two options instead.

Option 1: Oil Exploration and Production

It sounds almost too simple, but that’s because investing in oil producers just makes sense. Companies that pump crude from the ground sit on large fields that are full of oil. In addition, they sell their crude to the markets and generate gobs of cash. The higher the price of crude, the more valuable their fields and available products are.

There are multiple types of oil producers. U.S. companies like Exxon Mobil (XOM) and Chevron Corp. (CVX) are considered “majors.” (Note: TradeSmith Finance indicates that both are in the Green Zone and maintain an uptrend in momentum.)

They stand among the largest global oil producers and compete directly against large, state-owned producers like Saudi Aramco (Saudi Arabia), Petrobras (Brazil), and CNPC (China). They also compete against large multinationals like Total (TOT) and RoyalDutch Shell (RDS.A).

These companies tend to own large swaths of reserves around the globe and are less subject to the wild swings of crude prices due to the production or breakeven prices of their many fields. In addition, these companies are more likely to be vertically integrated and own storage, refineries, and other assets further down the supply chain.

Meanwhile, a large roster of other companies is known as “independents.” These companies don’t integrate and tend to focus on one specific element of the oil and gas industry. The IRS identifies these companies as those that don’t generate more than $5 million in retail sales of oil and gas each year. In addition, they do not refine more than 75,000 barrels of crude per day in a year.

Examples include ConocoPhillips (COP) and Marathon Oil (MRO). Like their major cousins, both oil independents sit in the Green Zone and maintain uptrend momentum.

Option 2: Master Limited Partnerships or MLPs

Long-term investors looking for exposure to the oil-and-gas sector should not overlook master limited partnerships. These companies don’t offer exposure to futures contracts and don’t even require you to look at oil reserves on a producer’s balance sheet. Instead, these firms own pipelines that pump crude from one place to the other. There are multiple reasons why MLPs are attractive investments, but I want to highlight the most important one.

They are considered alternative investments due to their tax structure. MLPs operate under a partnership structure that allows them to avoid payment of corporate taxes. Typically, shares are taxed two times, first at the corporate level and second at the investor level, when a shareholder pays capital gains taxes.

With MLPs, these companies avoid corporate taxes as long as they generate at least 90% of their revenue from “qualified” sources like natural gas or oil. These tax-preferred structures originated in the 1980s to encourage investment in U.S. natural resource development. Investors receive a quarterly distribution from the fund manager or distributor. Investors also receive a nice pro rata share of the depreciation allowed to the MLP by the government.

Examples of MLPs include Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), and MPLX (MPLX). All three provide dividends north of 7.4%, trade in the Green Zone on TradeSmith Finance, and remain in an uptrend momentum to start June.

If you’re bullish on crude oil, add them to your watch list and think about the best options that fit your risk-reward profile.

It’s simply amazing to me how much the world has changed in a year. We went from a booming economy to a screeching halt. Oil suffered dramatically, but it’s back.

And a lot of people lost a lot of money in oil stocks, ETFs, and futures.

So pay attention, because tomorrow, I’ll explain two ways of investing in this trend that you should avoid.

Trust me, these are not for the faint of heart, and you’re better off playing long-term energy companies that pay dividends and can appreciate over time instead of speculating on short-term price moves.