Oil and gas investing basics – everything you need to know

view original post

Investing in the oil and gas sector means putting your money in a sector with built-in risks: technical risks, socio-political issues and market risks are all inherent in oil and gas exploration.

Not to mention, the well could be a gusher, but it may also be a duster … meaning it yields nothing.

Finally, there are all the technical terms to overcome.

If you are looking to invest in the sector, you ought to know your BBOE (billion barrels of oil equivalent from your MMBOE (million barrels of oil equivalent) from your BCF (not the boating, camping, fishing kind, but the one billion cubic feet of natural gas kind), carbon, capture carbon sink, FEED (front-end engineering and design), fracking and fossil fuels — and that’s just the easy stuff.

Reserves and resources are also important, but this is no glossary – that is coming shortly.

This is an explainer about investing in the industry.

In this article:

Explaining the oil and gas sector

Despite a move to greener, more sustainable sources of energy, the oil and gas industry still has a major role to play in firing up our power stations, fuelling our cars and warming our homes.

Indeed, oil and natural gas remain major industries in the energy sector and still have a significant impact on the global economy.

The industry employs millions of people, can determine economic wealth and – rightly or wrongly – can even be a political football.

Millions of dollars are poured into the oil and gas sector each year either by companies looking to make the next big discovery, producers sending out their barrels to those in need and investors looking to make the next big profit.

Simply defined, the industry is divided into explorers and producers.

Both are looking to extract oil or gas from onshore or offshore wells and sell the raw materials to energy businesses.

The explorer/producer identifies potentially viable fields and then drills a well from which it can collect samples and test the findings.

If a well is deemed to have quality and quantity, production from the well begins.

Oil and gas deposits are extracted from the wells, stored temporarily, and shipped via a pipeline to a refinery.

This all sounds straightforward, but it isn’t. A company must work with engineers, construction contractors, data analysts and governments, including environmental protection bureaus to ensure that mining is safe and sustainable.

There are four stages of locating and extracting oil and gas:

  • Search and exploration – in which companies search for hydrocarbons and perform surveys to determine the amount of oil and gas reserves before drilling and geologists study the rock formations to identify if natural gas or oil is present;
  • Well construction – the construction and drilling of a well by creating a hole beneath the rock surface. Engineers will generally determine how many wells need to drilled and what the best method of extraction will be;
  • Extraction – extraction of oil and gas deposits from the well; and
  • Abandonment – when all reserves are extracted, the well is plugged and sealed and restored to meet environmental requirements.

Once extraction has occurred, the production process begins and this can be broken into two categories:

  • Midstream; and
  • Downstream.

Midstream is concerned with gathering and transporting crude oil, natural gas and refined fuels. This is normally done by pipeline, oil tanker and trucking fleets.

Downstream sees raw materials collected during the upstream process and filtered. This entails the refining of crude oil and the purification of natural gas. Products in this process include kerosene, natural gas, diesel, gasoline, LPG and others.

Here’s a simple video explainer:

[embedded content]

The other point of note when describing oil and gas companies is the difference between resources and reserves.

Resources are developed through seismic surveys or coring, while reserves are firmed up by exploration drilling and seeing what kind of resources come to the surface.

For example, 1P or P90 reserves are considered more valuable than a company with several 3P or P10 reserves.

1P or P90 reserves also reflect a certain amount of oil or gas with a 90% probability of it being produced.

3P or P10 reserves reflect a certain amount of oil or gas with a 10% chance of being produced.

Oil and gas are perhaps the most complicated of the mining disciplines, however, there are enormous rewards if you get in on the ground floor with small-cap oil and gas stocks.

That said, when they fail, they fail big.

So, what are the things you should look for in an oil and gas stock when determining whether to invest or not? Here are five market factors to be aware of.

The five rules of oil and gas investing

There are five important facets that drive oil and gas prices. You should examine these when on the prowl for your next oil and gas investment.

Of course, there is a lot more to it than the next five points, but these are strong fundamentals to begin with. They are:

  • The oil/gas price – market risk;
  • Portfolio;
  • Finances;
  • Management; and
  • Location.

1. The oil/gas price – market risk

The price of oil and gas may not be the first thing you look for, but it will be the first thing you notice.

After all, you are looking at the price of petrol and gas every time you pass a petrol station.

In 2021, the price of petrol in Australia has been higher than $1.90 and as low as $1.30. That 60 cents difference is a big fluctuation and has ramifications for stocks (we’ll get to that shortly).

It’s a similar trend elsewhere in the world.

The price of petrol usually coincides with the rise or fall of the price of crude oil.

It also coincides with macro events such as COVID-19.

ACCC chair Rod Sims said of the lows, “Low average petrol prices in the last financial year have come after prices reached record lows around the onset of the COVID-19 pandemic.”

COVID-19 also hit fuel demand.

“The pandemic has had an enormous impact on demand for petrol in Australia going back to March last year and this has influenced retail prices and gross retail margins,” Sims said.

This, in turn, impacts the price of stocks.

The Organisation of the Petroleum Exporting Countries, otherwise known as OPEC, also has a say.

OPEC actively manages oil production in its member countries by setting production targets: crude oil prices generally increase when OPEC production targets are reduced.

This is put into perspective when you consider OPEC member countries produce about 40% of the world’s crude oil and its oil exports represent about 60% of the total petroleum traded internationally.

OPEC’s actions influence international oil prices, while Saudi Arabia, OPEC’s largest producer, frequently affects oil prices when it makes changes to crude oil production.

The organisation can utilise available production capacity to indicate tightness of global oil markets and exert upward influence on prices.

OPEC recently held onto capacity, driving oil prices higher.

The US then released its own capacity to drive prices in the US lower.

Now, as citizens of the world that still drive oil-fuelled cars because electric vehicles are yet to become abundant and teleportation is yet to be created, we want to see low oil prices.

However, the higher the oil price, the better it is for investors.

So, what should investors look for in an oil and gas stock? Well, that is covered in the next four points, but, first and foremost, oil producers or explorers that can factor in fluctuating prices should be high on the list.

2. Portfolio

Essentially, companies with a diversified portfolio of assets that can weather price fluctuations and political manipulations are worthy of extra analysis.

There are many small oil and gas companies listed on the ASX with one or two main exploration targets.

These are riskier investment options. Although, depending on your risk appetite, they may be just what you are looking for.

The problem is their success is based on the success of just one or two wells, often referred to as wildcat prospects.

A less risky company will have diversified assets that may even include onshore and offshore prospects.

Offshore prospects have more potential to move a share price in either direction, as does lifecycle. That is, whether assets are in the exploration phase, proven resources phase, or production phase. See downstream, midstream and upstream definitions.

Note, larger companies such as BHP Group PLC (LSE:BHP) generally have proven producing wells, earnings and dividends.

3. Finances

Good exploration companies will have their exploration programs fully costed and laid out for shareholders to see.

There will inevitably be cost overruns, however, so if you’re considering an oil and gas company, transparency surrounding how much money the company hopes to spend in the next six months or a year is crucial.

Another thing worth considering is how much management’s remuneration comes to. Are they paying themselves hundreds of thousands of dollars when the assets are worth nothing?

Most listed company executives pay themselves in line with the work being done, but some will give themselves a nice little payday even when the company is languishing in debt with no progress made on its assets.

Other things to look for are:

  • The amount of cash a company has on its books;
  • How much cash it has on hand;
  • Any capital raises that may be required;
  • Farm-out deals, where it can farm out a percentage of the permit in exchange for money to a willing acquirer; and
  • Acquisition interest: are there any companies that may acquire some or all of its assets.

It’s good to investigate how the company intends to fund its exploration and production.

4. Management and team

As with any company you invest in, experience matters.

The board and the executive management team are crucial to the success of a company.

It would be a wise move to investigate their experience, the relevance of that experience to the project and any previous success they have had.

For instance, have they worked at a major such as ConocoPhillips (NYSE:COP) or Shell, or for a smaller company that became an acquisition target and was acquired for a princely sum?

If you’re investing in an oil and gas company, what experience does the team have in this field (collectively and individually)?

The team should be diverse and contain petroleum geologists, finance managers who can navigate a balance sheet and raise cash without too much dilution and those with high technical skills, including engineers, who are necessary in the highly technical world of well spudding.

5. Location

As with any real estate, location matters.

In oil and gas, access to the market is pivotal, which means the asset should be close to infrastructure that can help with shipping and near to the markets it is supplying or intends to supply.

Oil can be pumped at the wellhead and be put in an oil pipeline, stored in barrels, or put in a truck and shipped off. Each method requires the right infrastructure to get it to its destination, which should be as close by as possible.

Should you invest in oil and gas stocks?

Oil and gas stocks are some of the riskiest investments you can make. If the well is a duster, you will lose your money. But if there is black gold or an abundance of gas, these stocks can be quite lucrative.

By following the five rules you can mitigate risk.

However, there are further advantages.

Oil and gas investing benefits

  • Attractive to both day traders and long-term investors;
  • Liquid market;
  • Portfolio diversified;
  • Inflation hedge; and
  • Excellent profits can be made, and dividends paid out.

And there are disadvantages…

Oil and gas risks

  • Price volatility (see point 1 above);
  • Oil spills (never good for a company’s bottom line or the industry’s reputation);
  • Legal and regulatory risks, especially as environmental rules are tightened with the move to cleaner energy production;
  • Dividend cuts — can be due to low commodity prices, low cash balances and revenues from sales drops; and
  • Supply and demand challenges.

Before you rush into oil and gas investing, consider your appetite risk and whether it matches the potential volatility of the sector. And as with any investment, seek professional financial advice before diving in.