How to invest in oil as Iran tensions build

Fri Dec 30, 2011 10:05am EST

A sample of crude oil REUTERS/Miraflores Palace/Handout (VENEZUELA).

A sample of crude oil

Credit: Reuters/Miraflores Palace/Handout (VENEZUELA).

(Reuters) - As the year comes to a close, investors are finding themselves in a position they didn't expect: The U.S. economy looks to be growing more than most analysts anticipated.

It is hard to say whether that growth will continue to accelerate next year. But signs that the economy may be improving have lifted oil prices already. That's partly because energy companies often lead the way during expansions as more trucks loaded with goods clog the highways and more workers fill up their tanks on the way to work.

But don't run out and buy a giant energy company like Exxon Mobil Corp (XOM.N) or Chevron Corp (CVX.N) just yet. The uncertain dollar, the European Union and declining oil supplies will all likely affect oil prices in 2012. Oil plays in an uncertain world:

GLOBAL TENSIONS

The price of oil is notoriously hard to predict. Earthquakes, politics, and, increasingly, speculators can affect oil prices without notice.

That said, global tensions are likely to send the price of oil higher in the short term. It already near $100 a barrel, for a gain of almost $10 over seven days.

Iran's first vice-president warned on Tuesday that the flow of crude will be stopped from the crucial Strait of Hormuz in the Gulf if foreign sanctions are imposed on its oil exports. <ID: nL6E7NR19R> -- keeping the oil market on edge.

"Anything that happens that could lead to the closure of the (shipping lane) would be extremely bullish for oil," said Peter Beutel, president of Cameron Hanover, a consulting firm that focuses on energy risk management.

Recent bombings in Iraq, meanwhile, are raising concerns about stability there after the U.S. military withdrawal.

"There's no reassurance that something crazy won't happen there that sends... oil up to $150 or $200 a barrel," said Mike Breard, an energy analyst at Hodges Capital Management.

Investors do not have to wade too deeply into commodities to capture such gains. The United States Oil ETF (USO.P) tracks oil futures contracts closely.

"This fund is an efficient and effective means" to speculate in oil, noted Abraham Bailin, an ETF analyst at Morningstar, although this ETF can generate unwanted tax liabilities. He cited the IPath S&P GSCI Crude Oil Total Return Index ETN as one that with a more straight-forward tax structure.

GAS PRICES AND THE U.S. ECONOMY

Europe's economic woes could keep a lid on oil prices. Several euro zone countries are expected to slide into recession in 2012. And if one or more countries abandon the European Union's single currency, the euro, the U.S. dollar would likely move higher. Either could cushion the impact of oil prices for U.S. buyers.

"A stronger dollar means that there will be more money in consumer's pockets," said Quincy Krosby, market strategist at Prudential.

If a stronger dollar softens the impact of oil prices, companies that focus on the U.S. domestic economy like retailers and car makers ripe for outperformance, she said.

Small-cap stocks, which tend to be more immersed in the U.S. domestic market than the large cap companies, would likely benefit most from a dollar's climb, she said.

The PowerShares DB US Dollar Bullish ETF, which tracks the performance of the dollar against an index of six currencies, is one ETF option. It is up about 1.5 percent in the past month.

THE LONGER-TERM VIEW

As demand for oil grows and exploration becomes more difficult, more investment dollars will flow into the business of extracting crude.

"We've found all the easy oil in the world," said Breard, the energy analyst at Hodges Capital Management. Production from conventional oil wells is declining in places like New Mexico and Alaska, he said.

Drilling and service companies are more likely to benefit from this shift to harder-to-get oil than giant energy companies like Exxon because of an increasing reliance on deepwater drilling and fracking -- a process that uses high pressured liquids to extract oil from deep rock formations.

Drilling companies will also continue to benefit from an industry-wide upgrade of rigs, many built 30 or 40 years ago.

"In almost every scenario, limited global supply growth will likely mean higher-for-longer oil prices," over the next five years, said Francisco Blanch, global investment strategist at Bank of American Merrill Lynch.

Offshore drilling company Transocean Ltd (RIGN.VX) is one of Hodges Capital's largest holdings and could be a value play. The company's stock has fallen almost 11 percent over the last month after Brazil filed an $11 billion lawsuit against both Transocean and Chevron. The stock is down 42 percent from a 52-week high reached in January.

Halliburton Co (HAL.N), with services ranging from engineering to drill bits, is down 3.2 percent over the past month. Analysts see its fracking business expanding, and its shares gaining, in 2012.

IShares offers two oil-related ETFs. The iShares Dow Jones U.S. Oil Equipment and Services Fund holds energy services companies. Halliburton makes up 9 percent of the fund's holdings. The iShares Dow Jones Oil and Gas Exploration and Production Fund focuses more on drilling. Occidental Petroleum Corporation <OXY.N is the fund's largest holding at 16 percent of assets.

(Reporting by David Randall; Editing by Jennifer Merritt and Chelsea Emery)