Taking Advantage of Oil Prices

February 5th, 2015
in contributors

Investing Daily Article of the Week

by Robert Rapier, Investing Daily

In last week's Energy Letter I addressed the drop in the price of oil, arguing that it can't stay as low as it is for too long. The Cliffs Notes version is that over the past five years oil demand has grown by 5.2 million barrels (bbl) per day, but most of the new supply that has been added during that time cost quite a bit more than $50/bbl to produce. (Eighty-four percent of the new supply in the past five years has come from U.S. shale oil.)

Follow up:

So while the current oil price is driven by the panic of traders, supply/demand fundamentals will re-assert themselves before long and push the price back above $50. And the longer we stay below a sustainable price, the more we will ultimately overshoot to the high side.

In response to that column I received a follow-up question. This is the kind of question that comes up often from friends and family - investors who may not be especially sophisticated. I typically respond by sharing my personal beliefs about market trends, a bit of personal finance basics and some specific advice about energy companies.

Q: In the face of declining oil prices, how should middle-income earners respond? Do you think oil prices will remain low, and if not is there a way to lock in today's prices? I only have a total of $8000, I am inexperienced, and I don't know where to start.

Last week I argued that oil prices will not remain low. There are ways to lock in today's prices, but they aren't really appropriate for novice or relatively inexperienced investors. Further, these strategies can be extremely risky. But there is a lower-risk course of action I would recommend.

Over the long term, I favor three sectors of the market that I believe will outperform the broader market averages. Of course it is important to pick your entry points; these sectors can be volatile on a year-to-year basis. You really want to move money into these sectors while they're down.

The three sectors I favor are technology (think Apple and Google), health care (think aging Baby Boomers and the medicines they will need to maintain a good quality of life), and energy. I can't speak with a high level of expertise on technology and health care, so I personally just devote a portion of my portfolio to mutual funds in those areas that have good track records.

The novice investor may be more comfortable applying that same philosophy to the energy sector: Pick a decent mutual fund and let your money ride. But I think there is a fairly low risk strategy that should serve the novice investor well.

Before discussing specifics, I would first give two general pieces of advice to novice investors. When investing in stocks or mutual funds, only put in money that you think you won't need in the next three or four years. While I believe much of the downside risk in the energy sector is gone, there have been periods where an initial investment would have declined and taken that long to recover. You have to be mentally prepared to let that money ride unless something fundamentally changes with respect to the sector or the broader market.

One example of a fundamental change for energy stocks would be if global demand were to decline, since growth in total energy consumption has been the base case for this industry for quite some time. This would certainly require at the minimum a reconsideration of any investments made with that trend in mind.

The second piece of advice I would offer is to always maximize tax-advantaged accounts. What do I mean by that? Retirement accounts like 401k's and IRAs allow you to not only invest pre-tax dollars, but to compound the gains before paying taxes. This means that governments (state and federal) are chipping in on every contribution by letting you invest money that would have otherwise gone to pay taxes. That means that you could invest $1 and it might only cost you 70 cents (for instance) out of pocket.

An additional benefit of a 401k is that employers often match employee contributions. So, skipping out on a deal like that is just walking away from free money. If I could only give a few words of advice to someone entering the workforce, they would be to maximize the 401k contribution, learn to live without that money and invest in a growth mutual fund.

Now for the specifics on investing. Less experienced investors should proceed cautiously. There are times that I would advise them away from the energy sector in general (like a year ago, when I felt oil prices would fall) and I would always advise them to stay away from small companies, or those with a lot of debt. I would steer them toward larger, more diversified companies that pay decent dividends, and that I think will still be going strong a decade from now.

For the person who asked me this question, I recommended ConocoPhillips (NYSE: COP) stock. As a disclaimer, I worked for COP for six years, but there were times I would not have recommended its stock as an investment. Over the past five years, however, ConocoPhillips has undergone a major transition that should enable it to fare well even at $50/bbl oil. The company is large enough and globally diversified enough to cope with the downturn in oil prices better than most. The stock is among the few in the energy sector with a positive total return over the last 12 months. It pays a dividend currently yielding 4.5%, and when oil prices begin to climb the shares should enjoy decent price appreciation. There's not as much potential appreciation as in one of the riskier, aggressive oil companies, but also much less downside risk.

There are a number of other companies of the same type that I think would make equally good investments for a long-term buy and hold strategy that enables you to sleep at night. Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) are two that come to mind, and there are also numerous offerings among the Master Limited Partnerships (MLPs) that offer relatively low downside risk and yields in the 4% to 6% range.

That is the core of the basic strategy that I offer to friends and family when they ask me what to do, so consider it my best free advice for a novice investor. For more detailed or specific investment guidance, we delve much deeper into the topic in The Energy Strategist and MLP Profits. We also offer up more aggressive choices for investors who understand a bit more about risk, and have the tolerance for greater risk in return for potentially greater rewards.

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