Inflation Protection – Part 3 – Oil

In 2008 the price of a barrel of oil topped out at $147. So far in 2009 oil bottomed at $34 per barrel and then rose to $71.

Before the financial crisis changed everything, many people talked about the “peak oil” thesis. This is a prediction that world-wide oil production has reached its all time past and future peak. And, since world-wide demand for oil continues to rise the price of oil must go up to balance demand with supply.

We have since discovered that demand and the price of oil can go down – drastically. Nevertheless, the underlying equation remains intact even though short term fluctuations in demand can and do result in price fluctuations.

Several arguments speak in favor of using oil and natural gas as protection against inflation. In the long term the “peak oil” thesis is valid. Global demand is expected to continue increasing especially in China, India, and Brazil.

Even though more oil is discovered everyday it is discovered in increasingly more difficult and expensive to recover places. Because the costs of new oil & gas production are increasing; temporary decreases in demand that cause a fall in the oil price make marginal production projects uneconomic. They are then cancelled or abandoned. This automatic reduction of supply puts a floor under the price of oil.

Oil markets world-wide are priced in US dollars. When the dollar inflates relative to world currencies the price of oil in dollars goes up, even if the price remains stable in other non-inflating currencies.

Some will argue that alternative energy sources will reduce oil demand, but alternative energy sources are not yet commercially viable. They will likely first become commercially viable for generating electricity. It may be many years before they significantly replace oil.

If you choose to use the oil and gas markets to protect yourself from inflation there are several ways to do it. (1) You can buy oil futures contracts, contracts to take delivery of a quantity of oil at a set price sometime in the future. I strongly advise against this approach. (2) You can buy the common stocks of companies in the oil and gas business such as exploration companies, production limited partnerships, refiners, vertically integrated oil companies, and oil service companies. Or (3) you can buy energy sector ETF’s or mutual funds.

I’ve chosen to own shares of exploration companies, production limited partnerships, refiners, and integrated oil companies; all companies that pay significant dividends in addition to giving me the opportunity for share price appreciation as the price of oil rises.

Links to the Inflation Protection Special Report
Part 1 - The Need
Part 2 - Gold
Part 3 - Oil
Part 4 -TIPS
Part 5 - Consumer Staples
Part 6 - Commodities
Part 7 - Summary