Oil Stocks – Pros and Cons of Buying Oil Stocks

Oil and gas investments are good long-term buy-and-hold stocks because the economy always needs energy. Oil and gas demand is stable and always growing. Oil prices, on the other hand, are very volatile. When oil prices plunge, oil stock prices get hammered. Even with the price swings, long-term income investors can do very well in the oil sector.

Oil Stock Investing Pros

High-profit margins – Oil exploration is a high capital expenditure business. When oil reserves are in production, a well could provide revenue streams for 20, even 50 years. The profit margins on a productive well are high.

Steady dividends – The dividend streams make oil stocks an attractive investment for income-focused investors. A number of integrated oil majors are paying dividends in excess of 5%.

Tax advantages – Many energy investment vehicles provide tax advantages. One is the master limited partnership (MLP) – a partnership that invests in oil and gas assets and trades on public exchanges. MLPs benefit from the tax advantages of a partnership rather than a corporate structure.

Diversification – When oil and gas prices are high, the economy may experience slower growth due to the higher cost to run businesses, transportation and residences. This inverse relationship makes oil stocks a good buffer against an economic slowdown.

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Oil Stock Investing Cons

Volatile oil prices – Oil prices fluctuate in response to numerous business cycle and macroeconomic factors. The market dynamics can make it difficult to predict when oil prices have hit a bottom or peaked. Ideally, you want to buy oil stocks at the bottom before the upturn.

High-risk exploration – Exploration is a high-risk business. A promising reserve can end up being a dry hole. On the other hand, technology can bring too much success. Advancements in energy reserve extraction such as fracking have led to record reserve levels and put downward pressure on prices.

Oil Investment Tips

Invest in diversified portfolios – Integrated oil and gas players are involved in upstream and downstream businesses – E&P, refining, distribution and services. E&P operations in different stages of production spread across the globe further hedge risk.  If one well goes dry, another will be ramping up or coming online.

Analyse the price-to-book ratio – The price-to-book (P/B) ratio is used to determine if oil stocks are undervalued or overvalued. This metric tells you if the stock price reflects the book value of the company. To determine the book value, divide the stock price by the book value per share.  Big oil stocks are currently undervalued at a book value of 1.2, according to analysts. When oil prices increase, expect an average P/B in the 1.75 range.

Watch for M&A activity – Oil majors are also looking for undervalued companies. Before an upturn, merger and acquisition activity provides attractive investment opportunities. While stocks are trading at a deep discount, larger companies will swoop in and pick up cheap assets.

Once a company becomes a target, its stock price typically rises. Get in early, before the M&A activity starts; otherwise, you may have to pay too high a price to get a piece of the action.

Check out small-cap oil stocks – When oil prices are rising, small-cap stocks show some of the highest returns.  Caveat emptor. While some small-cap stocks have reserves and are in production, others only have exploration operations.

Many small-cap stocks are involved in wildcat drilling in unproven areas. Wildcat stocks involve high risk but the potential of a high return. The success rate of wildcat drilling is around 10%.

Futures contracts – You can buy option contracts to buy or sell oil in the future at a predetermined price for a fraction of the cost of investing in oil or oil stocks. The futures market provides a cheap way of investing in the oil market, but you need to be right about the direction of oil prices to profit.

Understanding the oil industry business cycle can help you make informed decisions about when to invest in this sector. When oil prices fell below $50 a barrel in the summer of 2015, investors started to ask, when will oil prices hit bottom and rebound? That bottom is the investor’s entry point.

Exploration and production stocks are the first to start rebounding. If oil inventory levels are high, then the inventory will first be worked down before E&P production picks up. When the oil sector is trading at a deep discount to its net asset value and oil prices are bottoming, it is a good time to pick up some cheap oil stocks.

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