The oil and gas market has gone through a terrible beating over the past six years. So, is this a buying opportunity? Or is there more pain to come in the oil & gas industry? And how can you know which oil and gas companies are the best to invest in? By understanding the fundamentals of investing in oil and gas you can improve your portfolio.
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The success or failure of oil and gas companies
If you’ve learned how to evaluate companies in other areas? You’ve probably looked at things like P/E Ratios, Free Cash Flow, or Dividend Yields. These things can sometimes matter for oil companies. But they are usually less important than they are for companies in other sectors.
But don’t worry. No one can know exactly what the price of oil is going to be five or ten years from now. But there are some factors that you can use to make reasonable guesses on what direction it is heading.
Factors that influence oil & gas prices:
The most important factor influencing the prices of energy products is probably economic growth. As technological advancements make workers more productive, the economy grows. This leads to higher incomes.
These incomes get spent on products that need energy to be produced. Some of these incomes also get spent on gasoline. As workers take vacations, go on joy rides, or consume more energy. As a result, demand for oil and gas rises.
At the same time, producers aren’t necessarily able to find new oil fields right away. The price can rise for many years before companies are able to produce enough to meet new demand.
This is why we often see rising oil prices during times of high GDP growth.
So, if you think the economy is about to start doing better than it has recently? This might be a good time to invest in the oil and natural gas sectors.
Low (or negative) real interest rates
Another factor that often leads to rising oil prices is low or negative real interest rates. Sometimes, this factor can even supersede the effect of low growth and a weak economy.
After the financial crash of 2008, oil fell from $140/bbl (barrel) to $40/bbl in just a few months. Governments all over the world started cutting short-term interest rates and doing quantitative easing. As a result, oil rallied from $40/bbl back up to $120/bbl over the course of the next two years. Despite the fact that the economy was extremely weak during this time.
When interest rates are low, consumers do not want to save as much. So, they drive more and buy more products that are produced using energy. At the same time, oil companies do not want to produce a lot if interest rates are low. This is because cash in hand depreciates while oil in the ground does not. So, low or negative real interest rates increase demand and restrict supply. And as a result, they drive up the price.
If you think that real interest rates are about to go down, then you might want to invest in oil and gas companies.
Another factor affecting the price of oil? Technology that lowers the cost of production. Example: some minor upstart oil company finds a cheaper way to extract oil out of the ground. It will have an incentive to dig more oil and as a result, the supply of oil will increase.
This will lower the price. But now the company is taking more market share from the bigger oil companies. It will still turn a greater profit all the while that the oil price is falling.
Yet, the industry as a whole, will decline as the price of oil falls.
What does that mean in the long-run? The fall in oil prices caused by the new technology will lead to greater incomes elsewhere. And the cycle will begin again. But this can take years.
If you think recent technological advances in energy production have run their course? It might be a good time to invest in oil and gas companies.
3 ways to invest in oil and gas
1. Commodity-backed ETFs
Are you interested in investing in the oil and gas sectors? Then you don’t have to invest in oil & gas companies. You can also invest in oil and gas directly, through oil and natural-gas backed ETFs.
The most popular oil and natural-gas backed ETFs are:
These ETFs attempt to track the price of oil or natural gas. To do this, they buy the nearest-dated futures contracts in the commodity that they want to track. And when the contracts are two weeks from expiring? They sell them and use the cash to buy the next to nearest contract.
But the number of contracts they buy depends on:
- Their share price
- How it relates to the nearest-dated contract.
If the share price rises faster than the futures contract? They issue new shares and use the cash to buy more futures contracts. If the share price rises slower than the contract? They sell some of their contracts and buy back their shares. In this way, these ETFs are usually able to track the price of oil or natural gas.
This can be useful. Because sometimes the price of producing oil rises faster than oil itself. For example, this happened from 2002-2003. When this happens, investing in oil will outperform investing in oil companies. In other times, the price of oil rises at about the same rate as the cost of production. In these cases, it’s better to invest in oil companies that pay dividends. Because they perform better than investing in oil itself.
There are also cases where the price of oil is falling, but the cost of production is falling faster. In such cases, holding oil stocks instead of oil will mitigate your losses.
The bottom line is that it’s a good idea to have some investments in each. That way, you can watch market developments to make portfolio adjustments when necessary.
2. Oil and gas company index funds
The easiest way to invest in oil and gas companies is to buy an index-fund that tracks the entire sector. The most popular of these is the Energy Select Sector SPDR ETF (XLE). It contains a basket of the biggest oil companies around. Such as Exxon Mobil, Chevron, Schlumberger Ltd., and ConocoPhillips.
But there are other oil and gas company ETFs as well, and some of them have outperformed XLE at different times.
Here are just a few of them:
- Vanguard Energy ETF (VDE)
- iShares S&P Global Energy ETF (IXC)
- JPMorgan Alerian MLP ETN (AMJ)
- ALPS Alerian MLP ETF (AMLP)
- Kinder Morgan Energy Partners (KMP)
- First Trust ISE-Revere Natural Gas ETF (FCG)
Oil and gas sector index funds provide a simple way to get exposure to energy stocks. But without spending a lot of time doing research. For many investors, this is the best way to invest in oil and gas stocks.
3. Picking individual stocks
Do you have more time to spare? Then you could build a portfolio by selecting individual stocks. If you’re highly skilled at doing this? You can get greater returns than you would from just investing in an index fund. It can also be more satisfying to know that your portfolio returns are coming from stocks you picked.
But this method is also riskier. So, it’s up to you to decide which way you want to go.
If you decide that you want to build a portfolio out of individual stocks, here are a few things to keep in mind.
Unlike the products of most businesses, oil is a limited resource. Oil companies only have a certain amount of oil in the ground. When that oil gets close to running out? The company will have to wind down and sell off its assets unless it can find more reserves. So, the first thing you want to find out when looking at an oil company is the amount of reserves it owns.
These come in three categories:
There’s a 90% chance for the company to dig out oil in usable form.
There’s a greater than 50% but less than 90% chance to get the oil.
There’s a greater than 10% but less than 50% chance to get the oil.
Possible reserves are unlikely to be obtainable. So, it’s usually best to focus only on the proven and probable reserves.
You can often find this information on the company’s website in the ‘10K’ annual report. There are also a lot of financial websites that keep copies of 10K reports.
Barrels of oil equivalent
It can be confusing to see the various types of oil and gas products the company produces. So, companies also state their reserves in the form of ‘barrels of oil equivalent’.
This is based on a calculation of the amount of energy each product produces. You can even simplify your analysis. By treating the company as if it has nothing but crude oil in the ground equal to the barrels of oil equivalent.
But keep in mind that sometimes certain oil or gas products have higher prices than crude oil. Even though their energy equivalent may be the same. So, this simplified method isn’t foolproof.
The enterprise value of a company is the cost of buying the entire company. Plus any debts it owes and minus any cash it has on hand or is owed to it. This is the cost of buying all the company’s physical assets. Including the oil reserves it has under the ground.
To find the enterprise value of a company, first look up the company’s market cap. Second, subtract the company’s cash on hand and any money owed to it from this number. Third, add the debts of the company. You can find this information on the company’s balance sheet.
Now you know the enterprise value of the company.
Once you know the enterprise value of the company and its reserve? You can determine how much you are paying for each barrel of oil the company owns underneath the ground:
- Add the provable and probable reserves together
- Divide them by the enterprise value
If the enterprise value/reserves are less than its peers? This is a sign that the company may be undervalued. As an investor, you may get greater returns by investing in this company.
But there may be some legitimate reason why other investors are not willing to pay a higher price for the stock. So, this doesn’t guarantee that the stock is undervalued. Yet, it’s a good place to start when evaluating it.
It’s all well and good if a company’s underground oil is cheap. But if interest rates are high or if you think the price of oil will go down sometime in the future? Then you need that company to get the oil out of the ground quickly. This where the production rate comes in. You can find this number in company reports. Usually, it’s listed as MBD or ‘million barrels per day’.
Enterprise value/production rate
If you divide the enterprise value by the production rate? You get an idea about how much you’re paying vs. the speed at which the company is producing oil. If this number is lower than its peers? It may mean that the stock is undervalued and stands to outperform its peers in the future.
You can find this in the company’s reports. It’s the total ‘net present value’ of the company’s proven reserve after discounting by 10%. This number is calculated using a forecast of future oil prices. The number is based on an average of its price over the past few years. It also factors in the production cost and a forecast of future production rate. This is based on the declining productivity of oil wells.
If an oil company’s market cap is equal to its PV10? It means that an investor can expect to make 10%/year from buying the company’s shares. This will only hold true if the oil price stays within the same range that it has been trading in over the past few years.
So, like other metrics, this one isn’t foolproof either.
Probably the best way to use this metric is to compare a company’s discount or premium over PV10 to its peers. Let’s say that an oil company’s PV10 is $80 billion and its enterprise value is $120 billion. It might be tempting to conclude that this company is overvalued because its EV is higher than its PV10. But maybe the oil price has been falling recently and is about to go back up.
Let’s say that a similar oil company has an enterprise value of $100 billion and a PV10 of $75 billion. This second company’s premium is only $25 billion whereas the first one’s is $40 billion. So this is a much stronger argument that the first company is overvalued.
If you’re the kind of investor who likes a more ‘hands on’ approach to building a portfolio? These metrics can help you to pick individual stocks that would suit you better than an index fund.
The oil and gas sector: past moves and future outlook
The oil and gas sector has had its ups and downs over the years. From 2001-2008, the Energy Select Sector SPDR ETF (XLE) outperformed the S & P 500 as a whole. This was a period of high inflation and rising oil and gas prices.
Yet, when the financial crash happened, this sector took a huge hit. But this was to be expected, given what happened to the market as a whole.
The XLE recovered. But it did so more slowly than the market as a whole. In the beginning of this period, the cost of oil and gas was rising as interest rates were cut and QE was enacted. But production costs rose faster than the prices of oil and gas. This prevented the sector from capitalising on this event. And at the end of this period? Oil and gas prices were flat and producers were barely able to keep costs low enough to stay profitable.
Despite the struggles of the sector, the XLE did manage to carve out a new high in the beginning of 2014.
Mid-2014 to early-2016
The XLE fell as the falling oil price finally overcame the ability of producers to cut costs.
The price of oil and gas bottomed in early 2016. And since that time, the XLE has once again started to outperform the S & P 500.
So where is the sector going in the future?
If inflation continues to pick up over the short-run? We can expect that the oil and gas sector will continue to outperform other sectors of the economy.
But inflation often encourages central banks to raise interest rates. If interest rates are raised too high, it may cause another recession. And it may be difficult for the oil and gas sector to bounce back, compared to other sectors of the economy.
Still, a recession will likely lead to another round of QE and another rapid rise in oil and gas prices. So, investors should be able to reduce their losses. How? By allocating some of their portfolio to energy commodity-backed ETFs. Such as USO and UNG.
Another strategy is to allocate some funds to energy companies. This should give greater returns if inflation rises faster than interest rates.
So, the outlook for oil and gas investments as a part of a diversified portfolio looks positive.