Oil: Black gold, Alberta tea

Call me crazy, or cynical, but the economic landscape is changing radically and many Victorians, British Columbians, and much of Canada are missing the boat. I am talking about oil and how it affects our way of life.

Oil means wealth — and Canada has it — but in our corner of the country its effects seem to elude us until gas prices hit a tipping point and we find ourselves paying more for gasoline than for rent.

But I can’t be too critical because I think many of the local high-end real estate developers and recreational property agents on the island have figured out that the fastest-growing segment of their business is coming from Albertans flush with cash from success in the energy market.

Oil is a global commodity and securing a reliable supply has been the most crucial economic strategy of Western industrialized nations since the end of the Second World War. However, in the past decade a new set of players has entered the game and are making large forays into untapped and undervalued deposits in our own backyard. China, India, and South Korea continue to explore acquisition opportunities, and their economies are flush with cash to pay for them. Canadian assets are being bought lock, stock, and barrel, so as the old saying goes: “If you can’t beat ’em, join ’em.”

Boom and bust

Most of us remember the theme song to The Beverly Hillbillies. I believe the second verse began with, “Well the first thing you know ol’ Jed’s a millionaire.” The show aired from 1962, when oil traded at $3 per barrel, to 1971, by which time the price had increased to $3.60 per barrel, or a 20 per cent increase in nine years. During this time pricing power shifted from the United States to the Organization of Petroleum Exporting Countries (OPEC) and culminated in the first series of price shocks in 1973 when prices jumped to $11.20 per barrel.

{advertisement} Since that time, oil has had several boom and bust cycles, with each successive boom attaining new high-water marks. The most recent boom/bust cycle for oil prices began in January 2007, when the price averaged $46.53 per barrel. By July 2008, the price had spiked at $137 per barrel. By January 2009, the price had plunged to an average of $34.57 per barrel. It took approximately 19 months for the price of oil to triple and six months for it to tumble by 74 per cent. Since that time, it has steadily risen to the mid-$80 range and many oil stocks have risen with it.

Trading oil used to be the domain of the rich and the very rich. Today, the average investor can also trade oil through the use of derivative investments such as exchange traded funds (ETFs) or index options. For business owners who use large amounts of gas, like truck and taxi fleets, some of their energy costs can be mitigated by using energy derivatives.

The question of how and why investors should invest in the energy sector is an easy one to answer. Oil is the lifeblood of the industrialized world. Prices are governed by several factors, including global economic growth forecasts, inflation expectations, geopolitical uncertainty, and speculative fever. Canada is a leading producer and our economy, our dollar, and our way of life are all influenced by an externally determined commodity price. More than one quarter of the S&P/TSX 60 stock index is energy companies.

Exposure to energy

If you’re a passive investor using a buy-and-hold strategy, you need to maintain a 25 per cent exposure to this sector. If you are an active investor, you will need to overweight or underweight the sector at different times of the cycle to outperform the passive investor.

Historically, to invest in oil, an investor needed the services of a commodities broker and would trade futures contracts with each contract representing 1,000 barrels or 42,000 U.S. gallons to be delivered at a fixed point in time in the future. A one-cent change in the price of oil translates into a $10 change in the underlying value of the contract. Strict rules govern the trading, settling, and delivery of each contract, and it requires a high level of sophistication and financial risk from investors. Speculative investors can take bullish or bearish positions depending on their expectations of future price changes, while hedging entities, such as large oil producers or large oil refiners, use the market to mitigate commodity risk.

For the average investor, ETFs are investment vehicles similar to mutual funds and designed to mimic the performance of specific stock, bond, and commodity indices, including oil and natural gas. The best website I have come across is etf.stock-encyclopedia.com. It has a list of U.S., international and Canadian ETFs. More importantly, ETFs allow investors to invest, speculate, or hedge their exposure to oil in rising and falling markets.

Long-term profit

On U.S. exchanges, investors can invest in Powershares, Proshares, Goldman Sachs, and United States Oil derivatives to gain long or short positions on various oil indices. Aggressive investors who want to speculate can buy ETFs that give them up to twice the upside or twice the downside return of the underlying index or commodity.

In Canada, Horizon Betapro offers two products designed to provide investors with 200 per cent of the daily increase or decrease in the TSX capped energy index (HEU and HED) or NYMEX oil futures near month contract less expenses and hedged back into Canadian dollars (HOU and HOD). A word of warning: If you are wrong on the direction bet, the leverage works double against you, so contact an investment advisor before you invest, or see www.hbpetfs.com.

IShares and Claymore Investments have created broad-based as well as specialized Canadian energy ETFs. The iShares capped energy index (XEG) is an index of approximately 46 of Canada’s largest oil and gas production and exploration companies as well as service firms such as the drilling companies. In addition, iShares manages five international energy-related ETFs that trade on U.S. stock exchanges. Claymore manages the Oil Sands Sector ETF (CLO), which contains approximately 16 companies and gives investors a more focused exposure to Canada’s largest known energy deposit.
Investors with higher risk tolerances can also invest in tax-assisted limited partnerships that purchase oil and gas exploration companies. In return for their high-risk dollars, investors participate in the success or failure of the energy companies. Drilling funds provide investors with tax breaks and a pro rata share of the physical oil or gas discovered. Contact your investment advisor to help you assess the suitability of these investments.

As a hedge against inflation and as an asset class, oil has proven to be a long-term profitable investment. Many foreign investors refer to the loonie as a petrodollar and, according to Statistics Canada, our immediate neighbours to the east have a real per capita personal income of $41,000 compared to $32,550 for British Columbians.