Is Oil and Gas a good investment?

The oil and gas industry has got some of the largest companies in its portfolio. Companies like ExxonMobil, BP and AramCo are the giants of the oil and gas sector, infact the IPO of AramCo valued the company at $1.7 trillion, making it the most valuable company in the world. Hearing the names of such mammoths of the industry may instill a sense of confidence, investors however should not let this false sense of confidence affect their investing decisions. Why? Simply because even though the oil and gas industry is a very lucrative industry, it is one which requires investors to have complete information before investing even a dime.

Risk Factors of the Oil and Gas industry?

Oil and Gas Investment

In terms of safety, no industry is completely risk free. The only risk free option for investment are government treasury bonds, apart from treasury bonds no investment option is free of risk. Every investment option has got its own risk profile that may vary over time due to different factors.

Every investment carries a risk - reward relationship. This relationship is important for investors because it helps them determine the return that they want to get from any investment. When it comes to companies in the oil and gas industry, investors have to determine the risk profile of individual companies to ascertain their risk profile. This industry in general has got a number of risk factors that the investors have to consider before making any investment.

Cyclic nature of earnings.

The earnings in the oil and gas sector are cyclical in nature. The stock prices follow these trends of booms and busts throughout the year. Investors therefore need to time their buy and sell strategy accordingly in order optimize their investments.

The price mechanism in the oil and gas industry is a complex one but to a large extent the prices are determined by supply and demand. The demand for oil and gas products rises in winter and drops in summer, this gives the oil and gas industry its typical cyclic nature, that brings in predictability to some extent which is good for investors.

Price Volatility Oil and Gas Investment

Price volatility is a major risk factor for the oil and gas industry. Although the forces of supply and demand determine the price to a large extent, there are also other contributing factors such as the level of production by the oil producing countries, sanctions upon certain oil producing countries, security of supply logistics and price wars.

2020 saw a major price war among the oil producing countries, that was coupled by a drastic reduction in demand due to Covid-19 induced lockdowns. This conjunction of two unrelated events caused the oil futures to tank, resulting in the price settling in the negative zone for a brief period of time.

These events make the price of oil and gas commodities very volatile. Volatility can be seen as both good and bad, depending on the objective of the investor. Short term speculative traders can make a lot of profit by accurately predicting the future price movements. It is very common among smart money investors like Warren Buffett to buy when the markets are low and sell when they are high.

Oil Price

Investors with a more long term view, are not interested as much in the short term price volatility as much as they are in the long term mean reversion of the prices of any company`s stock. Mean reversion is simply the tendency of the price movements to average out in the long run.

The graph shows the mean reversion of oil prices, it can be seen how over the last four years the WTI Crude prices have gone up and down but they have always returned to the $40 - $55 bracket. This is the mean reversion, which if followed correctly can save investors from losses and allow them to predict future price movements with greater accuracy.

The oil and gas industry is very lucrative for both of these types of investors because oil prices have a tendency to return to their average every time there is a boom or a bust. This allows investors to predict the future movements and therefore make profits by timing their trades accurately.

Safety and Security Issues

The risk factors related to safety and security issues are quite high for the oil and gas industry. Unfortunate incidents such as oil spills from drilling sites or oil tankers may not carry a high monetary cost but the loss of goodwill and social costs are far too high. The BP oil spill incident is still vivid in the minds of people today as the worst case scenario that can occur if an oil and gas company does not follow the required safety standards.

Oil and Gas Investment

Even if the industry standards are followed, disaster can strike anytime and bring with it loss of goodwill and share value for the company and the investors. Similarly security concerns are also a major risk factor. Oil and gas are key energy resources and in the case of any conflict, the threat of blockage of key supply lines is always there.

The presence of these risk factors does not mean that the oil and gas industry is a very high risk industry. No, this simply means that these risk factors are unique to this industry and by understanding these risk factors, investors can make more informed decisions to optimize their investments.

Market Performance

The market performance of the oil and gas sector has through history remained very good, in fact oil and gas stocks have outperformed other stocks over time. The most recent example is the price crash of March 2020, when many analysts signed oil off as a doomed commodity but a few months later in August, oil stocks set a record high in the S&P 500 index.

Oil and gas industry also has a very major advantage over other industries, the demand for oil and gas is not likely to go down anytime in the near future. Even though renewable sources are being used and promoted but oil and gas form a substantial portion of the global energy requirement and renewable sources at the moment are nowhere near to supplying that sort of energy. The demand for oil and gas will therefore remain high for the foreseeable future and this makes the oil and gas industry an active and lucrative industry for investors to invest in.

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