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Is There Still Time to Make Money in Oil?

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Oil prices have gone a long way in a very short time, which begs the question: Is now a good time to buy oil-related assets?

Since November 29, a day before OPEC agreed to cut production for the first time in eight years — along with Russia and some smaller non-OPEC producers — crude oil prices in the U.S. have surged 15% to just under $52 a barrel. 

(Related on ThinkAdvisor: Oil Climbs to 17-Month High on Saudi Pledge, Non-OPEC Output Cut)

Some analysts expect prices are heading toward $60 a barrel so long as the OPEC/Non-OPEC pact, which reduces supply by a total of 1.8 million barrels a day starting in 2017, holds.

“Oil prices will rise,” says Fadel Gheit, managing director and senior analyst, oil and gas, at Oppenheimer & Co. Inc. “The question is when and to what level. “If a lot of OPEC members abide by production caps it could come sooner than many expect; if not, it will take longer. The new normal is around $60 a barrel.”

Bill O’Neill, a founding partner of LOGIC Advisors, a commodities research firm, is skeptical. “Historically when we have these kinds of agreements, producers usually do half of what they agreed to.“ Also, says O’Neill, “supplies still seem quite substantial.”

Goldman Sachs analysts, who view the OPEC and non-OPEC pact as  “noteworthy” also expect that the production cuts will be about half of what was agreed on—just one million barrels a day—and have set a price target of $55 a barrel for benchmark U.S. West Texas Intermediate crude oil in the first half of 2017. At that price U.S. producers will increase output by 800,000 barrels a day in 2017, pushing prices even lower, to $50 a barrel in the second half of next year, according to Goldman analysts.

O’Neill is forecasting prices between $45 and $55 a barrel, noting that “U.S. rig counts are already rising week after week.”

Given these various scenarios for future oil prices, what should investors do now?

“Look where we are now and where you think oil prices will be and that will give you a hint where you think oil stock prices are going,” says Gheit. “It’s not the level of the oil price that matters to a stock’s performance. It’s the direction of the oil prices. Going from $40 to $50 a barrels is better than going from $80 to $60 a barrel.”

For O’Neill who’s forecasting that prices are more likely to fall than rise substantially from here, the recommendation is to do nothing other than “neutral market strategies,” using options.

For Gheit, who’s expecting higher prices, “It’s not too late to get into the market.” He expects that oil exploration and production stocks as well as oil service stocks, which have gained in the high single digits or low double digits since Nov. 29, have room to move higher, and not only because of higher oil prices.

He says oil companies will benefit from continued improvement in operating efficiencies and consolidation in the industry. “This is not a growth industry. Efficiency goes a long way,” says Gheit.

Even if the price appreciation for oil assets is limited, some stocks such as BP (BP) and Royal Dutch Shell (RYDAF), are paying dividends above 6% that should attract investors looking for regular income, says Gheit. Other E&P and oil service stocks and the Energy Select Sector Sector SPDR ETF (XLE) pay dividends ranging between 2% and 4%.

Another option for investors is midstream master limited partnerships (MLPs) involved in storing and transporting oil and gas. Most of these investments in oil and gas storage and pipelines have underperformed oil stocks not only since the OPEC/non-OPEC agreement but for the past several years.

Quinn Kiley, managing director of the MLP and energy infrastructure group at Advisory Research, which is the subdvisor for Nuveen and Guggenheim closed-end MLP funds, offers several reasons to favor MLPs now:

— Attractive yields, in the mid 7% range, which is greater than most other income-producing assets, such as corporate, government and muni bonds

— Favorable valuations because MLPs did not rally along with other oil-related assets

— Potential price appreciation not entirely based on commodity prices. “MLPs make money on volumes at the wellhead or at the end user utility. They don’t need high need prices to rise but to be stable enough to lead to more drilling production coming on.”

— Tax advantage. MLPs are pass-through entities that don’t pay any corporate taxes but distribute earnings to investors. When an MLP pays out more in distributions per share than it has earnings per share, which is generally the case, the IRS considers this a “return of capital” which is then deducted from an investor’s cost basis for tax purposes. The tax treatment, however, will complicate an investor’s tax filing.

The key things investors in MLPs need to remember, says John Buethe, equity analyst at Morningstar, “is that not all MLPs are created equally.” He encourages investors to think about what kind of cash flow and growth underpin the distributions from an MLP. A no-growth MLP should pay a higher yield than one that’s growing, says Buethe. But he notes if its yield is say, 4%, which is not much more than the 2.6% yield on a 10-year Treasury, it’s not likely to appreciate much in price.

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