How to Invest in Oil Stocks

Investing in oil stocks used to be a no-brainer. A growing world population and an increasingly globalized economy require vast amounts of fossil fuels to heat homes, ship goods across the ocean, and power jet-setters around the world.

Business is much less certain for participants in the oil and gas industry these days. The global oversupply of crude oil and natural gas, combined with fluctuating demand, has resulted in the energy sector significantly underperforming the broader stock market in recent years.

The major drops in oil prices in 2014 and 2020 shook the entire industry. And renewables continue to be cheaper and more widely used, as governments increasingly push companies to reduce their carbon emissions.

Even so, an investment in oil can still offer value. Here is an overview of how to invest in the oil market.

1. Keep an eye on oil prices

One of the main factors governing the oil industry is, of course, the price per barrel of crude oil. When crude oil prices rise, oil stock prices also tend to rise. When crude oil prices fall, the prices of most oil and gas stocks will also fall.

The reasoning behind this is quite simple. The costs of getting oil out of the ground, transporting it, storing it, and refining it into fuel and other products are essentially fixed. When a barrel of crude oil can be sold for more than the sum of these costs, oil companies make money. But when oil trades below the sum of these costs, at least some of these companies lose money.

It is generally better to buy oil stocks when oil prices are low and expected to rise rather than when they are already high. However, the price of oil affects different types of oil stocks in different ways. Checking the recent oil price is a critical first step in oil investing.

2. Know the Differences Between Oil Stocks

Not all oil stocks are created equal. In fact, “oil companies” can operate in entirely different parts of the industry. It is important to know what type of oil company you are investing in before buying.

  • Upstream oil and gas companies, also known as exploration and production companies, or simply E&P, scout sites around the world for oil and, once they find it, drill wells to extract it from the underworld. ground or seabed. E&Ps are the most sensitive to oil price fluctuations. The largest E&P in the United States is Conoco Phillips (NYSE:COP).
  • Intermediary companies transport, process and store crude oil, natural gas, natural gas liquids (NGL) and refined petroleum products such as lubricants. Intermediary companies often do business using fixed rate, long-term or take-or-pay contracts. Thus, their profitability is less affected by fluctuations in the price of oil. The main limited partnership Enterprise Product Partners (NYSE:EPD) is a major intermediary company.
  • Downstream companies refine crude oil into other products such as fuel or petrochemicals or sell refined products to consumers. Some do both. Gas station operators and refinery operators are two types of downstream businesses. The price of oil impacts the profitability of refineries because they earn their money on the “crack spread”, ie the difference between the price of oil and the price of refined products. So, downstream inventories are often hit when oil prices fall, as lower demand for refined products is one of the things that can weigh on crude prices. Phillips 66 (NYSE:PSX) is an important downstream company.
  • Integrated companies operate in more than one of the above segments of the supply chain. The so-called “integrated majors”, sometimes referred to as “Big Oil”, have significant upstream and downstream operations and some midstream capabilities as well. ExxonMobil (NYSE:XOM) and Chevron (NYSE: CVX) are two such oil majors.
  • Oil service companies provide equipment, operational support and upstream business services. These can include onshore or offshore drilling rigs, drills, underwater robots or pressure valves. When oil prices are low, upstream companies often try to reduce their service costs, which hurts oil service companies.
  • Oil Exchange Traded Funds (ETFs) allow you to invest in an entire sub-sector of the oil industry at once, as opposed to just one oil company. ETFs are baskets of stocks that trade like common stocks. A notable oil ETF is the SPDR Oil & Gas Exploration & Production ETF (XOP), which follows the entire upstream sector.

Image source: Getty Images

3. Focus on the dividend

The struggles of the oil companies don’t seem likely to go away anytime soon. Even if they are going through a period of short-term calm, such as the period between 2017 and 2019, world events beyond their control can quickly set them back. That’s why, for long-term investors who don’t want to have to constantly monitor the oil markets, dividend investing is probably the best bet here.

Integrated oil companies ExxonMobil and Chevron have increased their dividends every year for decades, with management prioritizing dividend preservation. Likewise, many intermediary companies – especially those with master limited partnership (MLP) structures – offer high dividend yields and reliable payouts.

When evaluating an oil company, don’t just look at the dividend yield (also known as the dividend-to-stock price ratio). Compare the yield to the company’s free cash flow. The best companies can pay their total dividend obligations and fund their capital expenditures using free cash flow, with some cash left over.

Also, look for a strong, high-quality balance sheet, as this provides additional financial flexibility (greater and better access to capital) and increases the likelihood that the company will be able to maintain its dividend during the next industry downturn.

4. Know when to invest in oil stocks

Any time is a good time to buy a great business.

It is important for investors to be aware of the volatility of the oil sector. For this reason, it’s best to focus on companies that are built to weather the inevitable downturns in the industry. This means focusing on those that are relatively immune to price swings, such as E&Ps with ultra-low production costs and integrated oil giants. Intermediate companies, with their contracts, should also be able to deal with adverse market conditions more easily than others in the supply chain.

Another way to invest in the oil sector is to focus on using it to generate dividend income. Many companies in the sector pay dividends with attractive high yields.

However, given the overall volatility of the sector, investors should choose their oil-fueled dividend stocks carefully, focusing on those with strong balance sheets and cash flow sustainability that allow them to generate cash flows. reliable income.

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Felix J. Dixon