The energy industry has undergone significant changes in the past decade, shifting from fears of "peak oil supply" to discussions around "peak oil demand." With the rise of renewable energy and electric vehicles, the future of traditional energy producers is often questioned. This blog post delves into the complexities of investing in the oil and gas sector in today's rapidly evolving landscape.
The Changing Meaning of "Peak Oil"
The term "peak oil" has evolved over the years. It once referred to the theoretical point when oil production would max out, leading to a gradual depletion of reserves. Today, it refers to the point when oil demand will start to decline, thanks to two major trends: the shale revolution in the U.S. and the plummeting cost of renewable energy.
Why Traditional Energy Producers Still Matter
Despite the uncertainties, traditional energy producers are far from obsolete. The timing of peak oil demand is still a matter of debate, and until then, oil and gas companies could continue to be profitable. Moreover, energy "supermajors" are pivoting towards cleaner energy sources, ensuring their long-term relevance.
The Energy Value Chain: A Diverse Investment Landscape
The energy sector offers a wide range of investment opportunities, from upstream companies involved in exploration to downstream companies that refine and distribute oil and gas. Understanding the value chain can help investors make more informed decisions.
Factors Influencing Oil and Gas Prices
Investing in the oil and gas industry requires a deep understanding of the factors that influence commodity prices, including supply and demand dynamics, geopolitical tensions, and market speculations.
In 1859, American businessman Edwin Drake used a steam engine to drill the world’s first modern commercial oil well in remote Pennsylvania. This sparked a major oil boom in the U.S., and even today, conventional "onshore" drilling remains the most common method of global oil production. OPEC, consisting of 14 oil-producing countries, has been a major player in the oil market since 1960. However, the shale revolution in the U.S. has shifted the dynamics, making the U.S. the largest oil producer in the world.
Oil and gas demand is generally linked to economic growth. The biggest uses of oil are in transportation and as a feedstock for the petrochemical industry. Natural gas is primarily used for electricity generation and heating. With the rise of electric vehicles and renewable energy sources, the demand landscape is changing rapidly.
Is The Price Right?
Oil and gas prices are determined by a complex interplay of supply and demand factors, visualized through a "cost curve." Seasonal trends, inventory levels, speculators' actions, and geopolitics all influence short-term prices. For example, natural gas prices usually rise in winter due to heating demand, while oil prices can spike due to geopolitical tensions. Speculators also play a role, in buying and selling futures based on price predictions. Understanding these nuances is crucial for investors.
How to Invest in the Oil and Gas Industry 📈
Now that you get the supply and demand dynamics behind the oil and gas markets and how prices are determined, how do you go about investing in the sector? The first (and most obvious) method is to invest in individual companies. Before you dive in, however, it’s worth knowing the most important drivers of a company depending on where it sits in the energy value chain ⛓
The key factors determining upstream companies’ profits are production volume, oil and gas prices, and operational efficiency. Rising prices increase all of these companies’ revenue – and upstream firms can grow this further by upping their production volume. Furthermore, the leaner and more cost-efficient a company’s drilling operations are, the more profit it can make from every dollar of sales. Still, of these three, oil and gas prices are the most important.
The most common reason for investing in upstream companies – also called exploration and production (E&P) companies – is as a bet that oil and gas prices will go up. But if they end up heading south instead, E&P companies’ stock prices can get slammed. Investing in the E&P sector is therefore risky – and should be approached with caution. (One silver lining, perhaps, is the potential to snatch up some of these companies more cheaply as an increasing number of big “institutional” investors divest from hardcore fossil-fuel stocks).
As for midstream companies that transport oil, gas, and finished products, the most important thing driving revenue is volume. The more oil and gas a midstream company moves around, the more money it’ll make because it usually gets paid on a per-unit basis. This makes midstream companies less sensitive to oil and gas prices – although higher prices obviously incentivize E&Ps to produce more, leading to higher transportation volume.
Successful investing in the midstream sector involves identifying those companies that stand to benefit from future volume growth and getting ahead of the game.
Alternatively, you can invest in the sector for its income potential. Because midstream companies’ earnings are volume-driven and sometimes regulated (similar to utility companies), they’re relatively stable – and allow firms to pay investors a consistent dividend. Another successful investment strategy therefore involves finding midstream players with attractive dividend yields which can be sustainably supported by their operations. Companies that can grow their dividend are even better, natch…
Finally, downstream companies that convert raw oil and gas into usable products benefit when the “spread” widens between the cost of their inputs and the price of their outputs. For example, if oil prices are falling but gasoline shortages are driving prices up at the pumps, refineries will see their margins expand and their earnings boosted. Another key variable is the “utilization rate”, a.k.a. the percentage of time a refinery is running. A business that can maximize this – by, for example, reducing maintenance time or avoiding unplanned outages due to accidents –will make more money from its operations.
Regardless of the type of company you’re investing in, you can do so by picking individual stocks or by using exchange-traded funds (ETFs). For example, if you think oil and gas prices are headed up, you can buy an ETF tracking a basket of E&P companies (e.g. XOP) or oilfield services firms (e.g. OIH) – the latter would benefit from increased drilling activity if energy prices are higher. If you want to be more conservative, meanwhile, you can invest in diversified energy companies – big businesses “vertically integrated” across the entire energy value chain. Because of the broad nature of their operations, these companies are less sensitive to energy price movements. Still, the midstream is even less sensitive – and these firms also tend to have higher dividend yields. MLPX is an example of an ETF that tracks midstream companies.
Of course, you can also invest directly in energy commodities instead of energy companies. Why not simply buy oil if you think its price is going up, instead of buying E&P companies and introducing a bunch of other variables into the equation? You can indeed invest in oil and gas through futures contracts – but you need to proceed with great caution, due to the inherent leverage involved in futures – and because oil and gas prices tend to experience big moves fairly frequently.
Alternatively, you can invest in an oil ETF (e.g. USO) or natural gas ETF (e.g. USG). But be warned: these don’t perfectly track oil and gas prices, thanks to fees and the fact they too invest in futures contracts rather than the physical commodity. And since futures contracts have expiry dates, these ETFs have to constantly reinvest funds into newer ones. This constant “rolling” of futures means the ETF’s performance will deviate from the underlying energy commodity.
And that’s that: now you know all about the energy industry, you can roll out the barrel and get involved. Let us know how you get on!
Incorporating the Knowledge into Your Strategy
Initial Assessment: Evaluate your risk tolerance and investment goals in the context of the oil and gas industry.
Market Research: Keep an eye on market trends, geopolitical factors, and technological advancements that could impact the sector.
Diversification: Consider diversifying your portfolio by investing in different segments of the energy value chain.
Sustainability: Look for companies that are making strides in sustainability and renewable energy integration.
Continuous Monitoring: Keep track of your investments and adjust your strategy based on emerging trends and market conditions.
The oil and gas industry is undergoing profound changes, but it remains a sector worth considering for investment. By understanding the complexities of the industry and keeping an eye on emerging trends, investors can make more informed decisions.