The time may be right for oil and gas investments

February 1, 2006

Finite commodities such as natural resources have generally performed well during inflationary periods.

A The fundamental outlook for oil remains relatively strong. Based on data from the Energy Information Administration, the world is now facing a supply constraint for the first time in history due to depleting reserves, refinery shutdowns, and an overall lack of new production.

The United States currently ranks eleventh in oil reserves worldwide. The number of operable U.S. refineries now stands below 150 compared with 324 in 1981. U.S. crude production is at a 50-year low. The International Energy Agency expects the world to hit peak production between 2013 and 2037 and then experience decreases at a rate of 3% per year.

In addition, many look at investments in oil and gas as a hedge against inflation. Finite commodities such as natural resources, including oil and gas, forest products, and precious metals, have generally performed well during inflationary periods.

Oil and gas prices are also extremely sensitive to many uncontrollable events, such as natural disasters, which can cause sharp price increases in the cost of these commodities. Events, such as last year's Hurricanes Katrina and Rita, created short-term interruptions in both the supply and demand sides of the equation.

Geopolitical risks also play a major role in oil and gas prices, as concerns continue to revolve around the war in Iraq, unrest within the Saudi Arabian royal family, and the ongoing situation in the Middle East. Other than these political risks, there are always risks within the entities on the production side. Worker strikes have historically impacted supplies of oil and gas, and this situation could certainly cause issues in the future.

On the other hand, there is always the possibility, or hope, that there will be a breakthrough with alternative energy sources that will lessen the demand for oil and gas. The other potential factor impacting prices would be a general decrease in demand for energy recourses, but the trends don't seem to support this, as consumption continues to increase on both a national and worldwide basis. The other major concern from an investment standpoint would be that the issues causing the price increases in 2005 are now already built into the prices today, potentially limiting near-term upside potential.

Those who decide to invest in oil and gas for a portion of their portfolio-either through commodities, mutual funds, or individual stocks-tend to focus on the supply/demand equation, with the lure of limited resources combined with increasing global demand. Great care, however, should be taken in selecting the most appropriate investment vehicle to gain exposure to natural resources. Diligent research should be completed prior to investing.

Q It appears unlikely that any type of new estate tax system will take effect this year. I have been thinking about implementing a dynasty trust. Should I do that now, or wait until the new laws are ultimately enacted?

A A dynasty trust is an irrevocable trust established by individuals with large estates, which benefits their children and grandchildren, as well as future generations. If properly structured and administered, a dynasty trust can give the trustee the discretion to make distributions to their heirs on an estate tax-free basis, as well as avoid the generation-skipping transfer (GST) tax. A properly drafted dynasty trust is typically structured to continue for multiple generations, being limited only by a specific state's "rule against perpetuities."