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Tickers in this Article: CVX, LINE, RDS.A, WHX, XOM
Befitting the nature of the industry, only a few plays on the crude production side aren’t so volatile as to be dangerous to a principled income investor, writes Josh Peters of Morningstar DividendInvestor.

Until now, our exposure to the energy industry has largely been confined to pipeline operators. Given that our strategy stresses reliable dividend returns above all else, it’s been easy to focus on the stable businesses that move energy commodities around over those that find and pump them out of the ground

Over the years, I’ve started to nurture the notion that any long-term investment portfolio could use some participation in energy production—even if only as a hedge.

Oil is a unique commodity in that it is a critical input for just about every other form of economic activity. It’s also a major item in ordinary household budgets, either directly (at the gas pump) or indirectly (utility bills, packaging, chemicals, the transport of everything else we buy, and so on).

If the price of oil goes up and takes the cost of living with it, so also should the value of a sound E&P firm. A falling oil price might not be good for an E&P stock in the short term, but at least the hit can be offset by relief on the cost-of-living front. In a sense, it seems to me that we are short oil unless we can have some investment in it.

Being short oil could be a dangerous position for the long term. I’m fond of the work of Jeremy Grantham, Wall Street’s high priest of mean reversion in asset prices. When he calls out a new paradigm (an asset that has left past statistical trends in the dust), I think it’s worth taking notice.

Grantham has lately gone much further than the widely popular theory of peak oil—that idea that global production will soon top out and start declining even with all the gigantic efforts and resources being thrown at the problem. He now worries that we’re running out of everything.

I won’t go that far, and I’m not enough of an expert in petroleum engineering to stake real money with or against the peak oil theory. That said, I am increasingly persuaded that the era of cheap oil is over. In late 1998, I can recall filling my pickup truck for just 77 cents a gallon. I should have saved and framed the receipt.

There are areas where oil that has already been found is still inexpensive to extract—Saudi Arabia, for instance. But in any commodity market, the price eventually reflects the marginal cost of production, not the lowest cost or even the average cost. Nobody is going to bother to find (much less extract) oil that costs $100 a barrel if it sells for only $50.

As the cheaper reserves are depleted, they are being replaced with far more costly supplies such as oil sands, shale oil, deep-water offshore, Arctic drilling, and so on.

Our view is that the cost of finding and extracting the marginal barrel of oil is now $95, and while we expect this price will continue to rise along with inflation, the political risks tied to an ever-growing share of the world’s supply mean that long-term risks are probably to the upside.

NEXT: Why to Avoid 2 High-Yield Plays, and Where You Should Invest

Investing in Oil for Dividends
There is no shortage of ways that investors can participate in a rising price of oil. At one extreme, we could forget about dividends entirely and invest directly in the physical commodity (or through one of the many oil exchange-traded funds).

While such an investment could serve as a hedge, I don’t find this appealing, not least because of a situation finance types call negative carry. A barrel of oil, or a rolling futures position, earns no income and actually costs money to hold.

At the other end of the spectrum, we could tap one of the high-yielding securities that represent a play on oil—royalty trusts, perhaps, or one of the master limited partnerships that are E&P concerns rather than pipeline operators. These leave me cold as well.

Consider Whiting USA Trust I (WHX). Right now it yields about 20%, but its payout soars and plunges with energy prices. Between November 2008 and November 2010, the trust’s quarterly dole was cut 60%.

Worse, it has a finite life—the trust estimates that it will run out of reserves and terminate with no remaining value in November 2015. This is an extreme example, perhaps, but still one to keep in mind.

The E&P partnerships like Linn Energy (LINE) can’t help but look better by comparison, but in my view they still fail to provide a sufficient margin of safety for their distributions.

Even if near-term output is hedged, maintaining today’s rate of distributions over the longer term means the price of oil cannot fall too much without a distribution cut. I don’t mind a certain level of cyclicality in earnings, but I won’t tolerate any material downside risk to our dividends.

But big oil stocks combine the features of a hedge and an operating business. The hedge comes from the reserves they’ve already got in the ground, which become more valuable as the price of oil rises.

But precisely because the companies don’t pay out all their cash flow as dividends, instead reinvesting some (but not all) to replace and increase reserves, the returns they’ve earned on retained capital have been highly profitable for shareholders—even though the cost of new oil has been going up.

None of this would matter much if I couldn’t buy one of the supermajors at a decent price, but lately the ones that I watch have gotten close to levels where I think I would be comfortable making purchases. While ExxonMobil (XOM) is the undisputed industry leader, I still don’t care for its policy of favoring share buybacks so heavily over dividends.

Chevron (CVX) looks more like ExxonMobil in terms of its payout ratio, but its yield is higher, recent dividend increases have been larger, and it is not a big repurchaser of stock—instead, it’s investing very heavily to increase production in the years beyond 2014.

Shell (RDS.A) devotes a much larger portion of its earnings to dividends, but not so much that a cyclical retreat in the oil price would make it a likely candidate for a dividend cut.

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