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Why I avoid oil shares like Woodside Petroleum Limited

The oil price has been on a tear lately with WTI crude up around 34% to US$65.70 per barrel in the past year.

This is good news for oil and gas stocks such as Woodside Petroleum Limited (ASX: WPL), Oil Search Limited (ASX: OSH) and Beach Energy Ltd (ASX: BPT) but perhaps not as good as you might think.

Both Woodside and Oil Search have ownership stakes in LNG projects and so a large chunk of their reserves are made up of gas rather than oil.

Similarly, only around a third of Beach Energy’s reserves are in the form of oil. Whilst oil and gas prices are linked, the correlation isn’t that strong and so higher oil prices don’t necessarily translate to an equivalent uplift in asset value for the three producers above.

Oil prices are volatile and hard to predict but broadly speaking they tend to increase in times of global economic prosperity. This is caused by increased industrial and consumer demand combined with static supply due to the time it takes to bring new projects onstream.

Also, like other commodities, oil retains its purchasing power when inflation spikes which is often a by product of strong economic growth.

These conditions exist today but are unlikely to persist. Rising inflation prompts interest rate hikes which eventually cause the economy to turn down taking inflation with it. So whilst the short-term outlook for oil companies is good, they remain highly cyclical and so the best time to buy them is when their share prices are suppressed.

I also believe that fossil fuels are in very long-term decline defined as the next 50 to 100 years.

The gigantic and mounting climate change threat means that this fate is inevitable to avoid widespread disaster and renewable energy technologies are already gaining market share. Such technologies will only improve over the coming decades and so the pace their adoption is set to accelerate.

Then there is the economics of the business of oil production. By definition commodity companies have no pricing power which translates to low shareholder returns through the cycle. Also, because reserves are continually diminishing funds must be constantly funnelled into exploration which is a unpredictable and therefore a particularly risky form of investment.

I tend to avoid the resource sector for these reasons and as far as I can tell the only saving grace of such shares over the long-term is their ability to hedge inflation. Even then, I think that holding some gold or inflation linked bonds is a better alternative since these also perform when the economy and stocks suffer.

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Motley Fool contributor Matthew Brazier has no position in any of the stocks mentioned. You can find Matt on Twitter @MattBrazier2

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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