How to profit from high oil prices

Oil prices have been on a tear this year and it doesn’t look as if this trend is going to end any time soon.

The war in Ukraine and subsequent political fallout has led to a complete restructuring of global oil and gas markets. Russia owns a quarter of the world’s gas reserves and more than 5% of its crude oil reserves. Former state oil producer Gazprom, which was privatised in 1992, is the world’s largest producer of natural gas. Last year, the company earned record profits of $29bn.

Western sanctions on Russia have stopped short of banning the purchase of the country’s hydrocarbons completely. Still, global oil and gas markets were already finely balanced before the country ostracised itself from the global community.

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The world's largest trading houses, which are responsible for the vast majority of oil and gas flows around the world, have essentially severed their connections with the country to protect their reputations. This disruption has been far more harmful than anything else.

India and China have stepped in to pick up some of Russia's output, but Western countries are fighting over the remaining supplies. And as is the case in most markets, when demand exceeds supply, prices rise.

However, there are other factors at play here. When the oil price crashed in 2014 following the US shale oil boom, producers around the world rebased their spending expectations. Companies like BP (LSE: BP) and Shell (LSE: SHEL) reconfigured their operations to make sure they’d be profitable at $60 a barrel oil.

That meant cutting spending on expensive offshore projects. Government policies designed to force producers to slow growth and focus more on green energy only added fuel to the fire.

As a result, the oil market was suffering from years of underinvestment heading into 2022. It had been able to get away with this thanks to plentiful supplies from Russia (among others). Now it has been forced out of the market, the West has a big problem.

Oil prices could go a lot higher from here

The nature of oil and gas production means countries and companies can’t just turn on the taps and produce more (or turn off the taps and consume less). It takes years to bring new production onstream.

Shell’s new North Sea natural gas project, Jackdaw, which could produce as much as 6.5% of the UK’s gas consumption at its peak, won’t be ready until the middle of the decade at the earliest.

Consumers and businesses can’t stop consuming gas and wait for the new production to come onstream. The mismatch between demand and supply seems set to last.

Goldman Sachs thinks the Brent crude oil price could hit $140 this year on rising demand. Meanwhile, my colleague Dominic Frisby thinks that could be a conservative estimate. His calculations suggest $185 oil is not unreasonable and there could even be a chance of $300 oil.

That being said, oil prices can’t go up forever; sooner or later demand destruction will start to take place. Consumers won’t be willing or able to pay higher prices and they’ll stop buying. But Goldman thinks oil will have to hit $185 a barrel for that to happen – which suggests there’s more scope for prices to move higher in the near term.

How to invest for rising oil prices

There are several ways for investors to profit from this future growth. The most obvious is to buy oil producers. As I have noted several times before, my favourite buys in the sector are the Big Oil companies like Shell, BP, ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX).

Not only do these businesses have the strongest balance sheets, biggest economies of scale and vertical integration throughout the petroleum industry, they’re also well-positioned to ride the shift away from hydrocarbon energy towards green power.

I’m not saying oil and gas will become irrelevant any time soon, but the world is shifting away from hydrocarbons, and I think it would be downright foolish for investors to ignore that.

This is the main reason why I’m not so optimistic on the outlook for smaller, less diversified producers such as Tullow (LSE: TLW), Harbour Energy (LSE: HBR) and Enquest (LSE: ENQ). Due to their focus on oil and gas production, these businesses might be some of the best ways to invest in higher oil prices (in that they’ll go up further and faster if prices keep rising). But this benefit is also a drawback: if prices slump, they have nothing to fall back on.

Aside from the Big Oil companies I’d consider oil production exchange traded funds (ETFs). The SPDR MSCI Europe Energy UCITS ETF (LSE: ENGY) owns the 12 largest oil & gas companies in Europe. Shell and BP alone account for just over 50% of the fund.

The iShares Oil and Gas Production ETF (LSE: SPOG) has a larger international footprint with 62 rather than 12 holdings. It has a greater focus on larger producers, rather than integrated players.

Investors may also want to consider owning oil services. The fortunes of producers can fluctuate with oil prices, but equipment will always need to be maintained. The VanEck Oil Services ETF (NYSE: OIH) aims to track the performance of US-listed companies involved in oil services to the upstream oil sector, which include oil equipment, oil services, or oil drilling. It has 25 holdings, the largest of which is Schlumberger (NYSE: SLB).

Another option is the Alerian Midstream Energy Dividend UCITS ETF (LSE: MMLP). Also highlighted by Dominic, this ETF offers exposure to “midstream energy companies involved in the processing, transportation and storage of oil, natural gas and natural gas liquids in the US and Canadian markets.” It yields 6% and offers UK investors access to a North American market that does not exist at home.