Profiting From Increasing Oil Prices

The high price of oil can, and most likely will, negatively affect your cost of living, but there is the opportunity to turn that lemon into lemonade with a strategic investment in oil production.

Oil prices are high and, unfortunately, they have stabilized at higher prices during the past decade. This may be bad for your everyday life, but you can profit off it a little with the right investing strategy.

Higher oil prices translate to higher raw material costs for almost every product we buy, and higher gasoline prices. As a result we all have less discretionary income. With increasing oil costs and reduced consumer spending, it is no surprise that the stock market underperforms when oil prices are high.

Jet fuel typically accounts for one-third of all airlines’ costs, resulting in airlines profitability being subjective to any change in the price of oil. Due to airlines’ vulnerability to high oil prices, Southwest Airlines in 1994 began to hedge its oil prices. When oil prices spiked from 2005 to 2008, Southwest Airlines managed to become the most profitable airline because of its foresight to control the externality of fuel costs.

With current oil prices many of our families would want to hedge against higher costs from rising oil prices. For most individuals, taking the Southwest hedging strategy is overkill and would involve hiring a staff and making an unnecessary major financial commitment. Without taking the bold steps of Southwest, we still have options to protect ourselves against rising oil prices.

Investors wanting to offset potential losses from rising oil prices can buy stock in major oil companies. As oil prices rise, so do the prices of oil stocks, helping to create new profit that can subsidize your household’s rising costs that result from higher oil prices. Unfortunately, with WTI crude oil currently over $95 per barrel, many of stocks like Chevron and Exxon are already trading at a high multiple of earnings, making this a less-than-optimal time to buy these stocks.

Many of my clients who wanted to hedge against moving oil prices have invested in limited partnerships that drill for oil. These partnerships provide monthly income that will rise as oil prices increase. This monthly income can be used to offset increasing costs that have resulted from higher oil prices.

Investors looking to hedge against rising oil prices should focus on developmental drilling programs as opposed to highly speculative wildcatting programs. A good developmental drilling program will focus on diversifying the drilling risk with multiple wells in an oil field with known reserves and high drilling success rates.

For investors in domestic drilling there are large tax incentives. The intangible drilling costs (IDCs) — often 80% to 100% of the invested amount — are tax deductible in the first year. Depending on your state’s income tax rate, an individual who invests $25,000 will save roughly $7,000 to $8,750 on taxes in the first year. This deduction is part of the tax code and is designed to encourage investment in the production of American hydrocarbon resources.

High oil prices in tandem with advancements in the last five years in horizontal drilling and fracking technologies have made for very successful domestic oil wells. A traditional vertical well drilled to a total depth of 6,000 feet in the Permian Basin costs approximately $1.2 million and should produce an initial production rate of 60 to 75 barrels a day. A horizontal well drilled to a total depth of 6,000 feet with a 4,000-foot lateral extension in the Permian Basin costs approximately $3.6 million and could produce an initial production rate of 400 to 1,000 barrels a day.

The high price of oil can, and most likely will, negatively affect your cost of living, but there is the opportunity to turn that lemon into lemonade with a strategic investment in oil production.

Michael Roberts is a resident of the Chicago suburbs and has a degree in economics from the Miller School of Business at Ball State University. He is a Series 7, 22, and 63 Registered Representative with Alliance Affiliated Equities Corporation, a broker dealer focused on alternative and U.S. tax-advantaged investments. He invites questions or comments at 800-453-5155 or by email at mroberts@aaeconline.com.