Rising Oil Prices: Here’s Four Ways To Play Crude Oil

Oil is trading well over $70 a barrel - at its highs for this year - and just off nine-month highs of $73.20, seen last October 21, oil has been steadily rising. Oil prices have risen nearly 100% since their $38 a barrel lows seen last January.

Unfortunately - at a time when consumers can’t afford a wallet drain - retail gasoline prices across the United States have risen to $2.55 a gallon on average, and over $3.00 a gallon in places like California.

As you drive by the gas station and see the now familiar price changes - sometimes by the hour - you might wonder what’s really affecting the price you pay…

Investors, of course, want to know if there’s a good way to play the price moves. Let’s take a look at the two biggest drivers of oil prices and ways you can play its movements.

Oil Prices Rise As Production Costs Vary Widely

As with any natural resource we use, crude oil has costs associated with its production that are relatively clear, but nonetheless can vary widely.

Those variations come about almost entirely based on where the oil is. Since we’ve been using the black goo for nearly 100 years, it stands to reason that most of the easy, cheap oil deposits have already been found.

Taking a look at the costs to even find the stuff:

• You’ll find deep-water exploration is far more expensive than land-based exploration. You need a sizeable exploration vessel, capable of operating in some of the world’s angriest oceans for months at a time.It has to be equipped with highly sophisticated instrumentation and software to be able to “see” potential crude oil deposits as deep as seven miles below the surface of the ocean. You also need a crew of mechanics to keep it all working, and petroleum engineers and geologists to interpret the data.
• Land-based exploration - on the other hand - can be done from a well-equipped van, by one or two petroleum geologists.Then there’s production costs: land based oil is cheap to drill for. Land-based drills can fit on the back of a few tractor-trailers and can be torn down, moved and setup at a new location with relative ease. In addition, it’s much less expensive to extract.

Land based production is definitely preferred. Unfortunately it’s not where the big new finds are made.

As you go offshore into deep water, things get expensive fast: deep-water extraction is a financially losing proposition with prices anywhere below $75 to$80 a barrel, compared to as little as $25 to$30 a barrel for some land-based deposits.

But exploration isn’t the only cost of crude oil. Refining, transportation and taxes make up the remaining cost of what you pay at the pump. And that’s really just the start of what we pay for gas…

The Other Price Drivers: It’s Not Always What You Think

When crude oil prices spiked to $147 a barrel, there was no question that speculation played a significant role in getting it there. But speculation also played a role it getting it to $38 a barrel, too.

In the end, for oil and just about everything else, it all comes down to supply and demand. We’re in a recession, and demand continues to slacken. OPEC’s response has been to cut supply, with the thought that - everything else being equal - prices would eventually stabilize at some level.

But everything else isn’t equal: The Federal government has been dumping cash into the financial system at unprecedented levels. It’s caused the dollar to drop in value with respect to other world currencies and with respect to gold.

Since oil on all the world markets is priced in dollars, its price rises as the value of the dollar declines. It’s one of the reasons many oil-producing countries have suggested that the price of oil be tied to a basket of currencies instead of just to the dollar.

Unfortunately, there aren’t any other currencies that are as abundant or - more importantly - strong enough to handle the sheer volume of the transactions that occur daily in the oil market.

So we have demand and supply destruction in a race downward here in the United States that’s kept oil inventories high - up until a few weeks ago. Add to that steadily rising demand coming from emerging markets around the world. Throw a declining dollar into the mix and stir.

The result is rising oil prices - in all likelihood heading to $80 a barrel or possibly even higher by the end of the year.

Three Ways to Play the Pickup in Crude Oil Prices

As for investing in crude oil, here are three ways to get long in oil and one way to short it:

• Certainly one of the big drillers like TransOcean (NYSE:RIG) is a great long-term play on rising oil prices, as their shares closely mirror the rise and fall of the commodity itself. Shares of the drillers have been absolutely punished, and TransOcean is off nearly 50% from its 52-week high.
• The United States Oil Fund LP (USO) is an ETF designed to track West Texas Intermediate (light, sweet crude oil) prices. The fund invests in futures contracts for crude, heating oil, gasoline and other petroleum-based fuels.
• If you don’t mind some potential added volatility, PowerShares DB Crude Oil Double Long ETN (DXO) is a long-leveraged Exchange Traded Note available to investors. It’s designed to track the performance of certain crude oil futures contracts, plus the returns from investing in three-month Treasuries.
• But if you’re a bit more active in your trading, or if you feel oil is ready for a pullback, you might consider a short approach. PowerShares DB Crude Oil Double Short ETN (DTO) is designed to do just the opposite of DXO if you feel that our current rally in oil prices is overdone.For the reasons above, I don’t believe that’s the direction we’re going, but I think DTO is one of the better ways to play a short approach to oil.

Any way you play it, you need to be aware that there are many factors that can affect oil’s price, and by extension, any investments you have that are tied to it. Keeping an eye on the biggest drivers of these prices will give you a leg up on the average investor.

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