A Guide To Investing In Oil Markets

Posted: May 12, 2011

Tony Daltorio

Contact | Author Bio

ARTICLE HIGHLIGHTS

• You can invest in oil-price fluctuations without opening a futures account.
• One way is to invest in stocks of oil drilling and service companies.

The oil market can be very confusing to both the professional and individual investor, with large price fluctuations sometimes occurring on a daily basis. This article explains the forces driving the market and how to have a financial stake in oil-price fluctuations without opening a futures account.

Price-Driving Influences
Demand

The Organization of Petroleum Exporting Countries (OPEC) and the International Energy Agency estimate the current world demand for oil at between 86 million to 87 million barrels per day in 2008. When the price of oil rises, this decreases demand in the United States, but demand from growing emerging market economies is expected to increase as these countries industrialize.(For related reading, see What Is An Emerging Market Economy?)

Some emerging market economies have fuel subsidies for consumers, and an estimated one-quarter of the world's demand for oil in 2008 comes from nations that have such subsidies. However, subsidies are not always beneficial to a country's economy, because although they tend to spur demand in the country, they may also cause the country's oil producers to sell at a loss. As such, removing subsidies can allow a country to increase oil production, thus increasing supply and lowering prices. In addition, cutting subsidies can decrease any shortage of refined products have been alleviated, since higher oil prices give refineries an incentive to produce products, such as diesel and gasoline.

Supply

On the supply side, in 2008, approximately 85 million to 86 million barrels of oil were produced each day. The discovery of new reserves in Brazil in 2007 is a bright spot, but the oil fields in Mexico and the North Sea are experiencing steep declines in production. (For more on oil production shortfalls and their implications, read Peak Oil: What To Do When The Well Runs Dry.)

In OPEC, most countries do not have the ability to pump out much more oil. Saudi Arabia, the one exception, has an estimated spare capacity of 1.5 million barrels of oil per day as of 2008.

Nigeria has also become important to the oil market, but the country has a history of instability and rebel attacks, which can severely curtail oil production in this country. These rebels, who, attacked a deep-water drilling vessels far offshore in June 2008, brought Nigeria's oil production to the lowest levels in 25 years. As a result of the attack, the country pumped out only 1.5 million barrels per day thereafter, instead of the 2.5 million barrels per day it could be producing. (For more on how supply and demand impact the price of oil, read What Determines Oil Prices?)

Quality

One of the major problems the oil market faces is the lack of high-quality "sweet" crude, the type of oil that many refineries need to meet stringent environmental requirements, particularly in the United States. Much of the high-quality oil imported into the United States comes from Nigeria and surrounding African nations; according to the U.S. Department of Energy, together, Nigeria and Angola exported more oil to the United States than Saudi Arabia in 2007.

Speculation

Aside from supply and demand factors, another force driving oil prices has been investors and speculators bidding on oil futures contracts. Many major institutional investors now involved in the oil markets, such as pension and endowment funds, hold commodity-linked investments as part of a long-term asset-allocation strategy. Others, including Wall Street speculators, trade oil futures for very short periods of time to reap quick profits. Some observers attribute wide short-term swings in oil prices to these speculators, while others believe their influence is minimal. (For more on trading oil futures, read Become An Oil And Gas Futures Detective.)

Investment Options

Regardless of the underlying reasons for changes in oil prices, investors who want to capitalize on energy price fluctuations have a number of options. One simple way for the average person to invest in oil is through stocks of oil drilling and service companies. (For help in how to choose specific companies in the industry, see Oil And Gas Industry Primer.)

Several sector mutual funds invest mainly in energy-related stocks as well. (For more information on sector mutual funds, see An Introduction To Sector Funds.)

Investors can gain more direct exposure to the price of oil through an exchange-traded fund (ETF) or exchange-traded note (ETN), which typically invest in oil futures contracts rather than energy stocks. Because oil prices are largely uncorrelated to stock market returns or the direction of the U.S. dollar, these products follow the price of oil more closely than energy stocks and can serve as a hedge and a portfolio diversifier. (Learn more about the advantages of ETFs and ETNs in Exchange Traded Notes - An Alternative To ETFs.)

Investors have a number of ETF and ETN options to choose from, such as a single-commodity ETF (e.g., oil only) or a multi-commodity ETF that will cover a variety of energy commodities (oil, natural gas, gasoline and heating oil). There are many choices for investors.(For more information on energy investment options, see ETFs Provide Easy Access To Energy Commodities.)

The Bottom Line

The oil market provides a diverse array of options for the potential investor. From indirect exposure via an energy-related stock to more direct investment in a commodity-linked ETF, the energy sector has something for almost everyone. As with all investments, make sure you do your research or consult an investment professional prior to committing your money, and remember the information outlined above when predicting price changes to help ensure a profitable investment.

For alternative-energy investment options, read The Biofuels Debate Heats Up.

by Tony Daltorio

Tony Daltorio worked for more than 20 years in the investment business. Most of those years were spent with Charles Schwab & Co., both as a broker and a trading supervisor. As a supervisor, he oversaw, at times, dozens of employees. Daltorio was trading supervisor during the 1987 crash and was responsible for millions of dollars of customers' orders.

Read more: http://www.investopedia.com/articles/economics/08/investing-in-oil-markets.asp#ixzz1hckEW4QD

Oil And Gas Industry Primer

Posted: May 21, 2007

Bryn Harman

Contact | Author Bio

A very fundamental aspect of equity investing is understanding the companies and sectors in which you invest. In the equity universe, there are a number of sectors, and equity investors require some specialized knowledge to make educated investment decisions. One of those sectors is the oil and gas sector, which is teeming with complicated terminology that can overwhelm investors new to the space. With a basic understanding of this terminology and the oil and gas business in general, investors can better understand the fundamentals of oil and gas stocks. Read on as we take you through the basics. (For related reading, see the Industry Handbook.)

Hydrocarbon Basics

Crude oil and natural gas are naturally occurring substances present in rock amidst the earth's crust. The origin of oil and gas is organic material - the remains of plants and animals - compressed in sedimentary rock such as sandstone, limestone and shale. Sedimentary rock is a product of sediment deposits in ancient oceans and other bodies of water. As layers of sediment were deposited on the ocean floor, decaying remains of plants and animals were integrated into the forming rock. This organic material eventually transformed into oil and gas after being exposed to a specific temperature and pressure range deep within the earth's crust.

Because oil and gas are less dense than water, which occurs in huge quantities in the earth's subsurface, oil and gas migrate through relatively porous sedimentary source rock toward the earth's surface. When the hydrocarbons are trapped beneath relatively less porous cap rock, an oil and gas reservoir is formed. These reservoirs, which are simply layers of rock containing relatively large quantities of oil and gas, are our source for crude oil and gas.

In order to bring the hydrocarbons to the surface, a well must be drilled through the cap rock and into the reservoir. Drilling rigs work in a similar fashion as a hand drill; a drill bit is attached to a series of drill pipes and the whole thing is rotated to make a well in the rock. Once the drill bit reaches the reservoir, a productive oil or gas well can be completed and the hydrocarbons can be pumped to the surface. When the drilling activity does not find commercially viable quantities of hydrocarbons, the well is classified as a "dry hole". Dry holes are typically plugged and abandoned.

Production and Reserves

Exploration and production (E&P) companies focus on finding hydrocarbon reservoirs, drilling oil and gas wells and producing and selling these materials to be later refined into products such as gasoline. This activity is usually referred to as upstream oil and gas activity. Today, there are hundreds of public E&P companies listed on U.S. stock exchanges. Virtually all cash flow and income statement line items of E&P companies are directly attached to oil and gas production; therefore, investors should develop an understanding of basic production terminology when assessing E&P stocks.

Exploration and production companies measure oil production in terms of barrels. A barrel, usually abbreviated as "bbl", is 42 U.S. gallons. Companies often describe production in terms of bbl per day or bbl per quarter. A common methodology in the oil patch is to use a prefix of "m" to indicate 1,000 and a prefix of "mm" to indicate 1 million. Therefore, one thousand barrels is commonly denoted as "mbbl" and one million barrels is denoted as "mmbbl". For example, when an E&P company reports production of 7 mbbl per day, it is referring to 7,000 barrels of oil per day.

Production of gas is described in terms of standard cubic feet, which is a measure of quantity of gas at 60 degrees Fahrenheit and 14.65 pounds per square inch of pressure. Similar to the convention for oil, the term "mmcf" means 1 million cubic feet of gas. One billion cubic feet is denoted as "Bcf" and one trillion cubic feet is denoted as "Tcf". Note that gas market prices are sold on the New York Mercantile Exchange futures market in terms of million British thermal units, or "mmbtu", which is roughly equivalent to 970 cubic feet of gas. Investors frequently think of an mcf of gas as being equivalent to one mmbtu. (For related reading, see What economic indicators are especially important to oil traders?)         

E&P companies often describe their production in units of barrels of oil equivalent (BOE). In calculating BOE, companies usually convert gas production into oil equivalent production using an energy equivalent basis. In this basis, one BOE has the energy equivalent of 6,040 cubic feet of gas - or roughly one bbl to 6 mcf. Oil quantity can be converted into gas quantity in a similar fashion and gas producers often refer to production in terms of gas equivalency using the term "mcfe". Note that the energy conversion basis often is not reflected in the respective market prices of oil and gas. (For related reading, see Getting A Grip On The Cost Of Gas.)   

E&P companies report their oil and gas reserves - the quantity of oil and gas they own that is still in reservoirs in the ground - in the same bbl and mcf terms as above. Reserves are often used to value E&P companies and make predictions for their revenue and earnings. Note that reserves' values are not GAAP figures and they are not directly booked into a company's financial statements.   

Because new reserves are the primary source of future revenue, E&P companies spend a lot of time and effort in finding new petroleum reserves. If an E&P company stops exploring, it will generate revenue from a finite and depleting quantity of petroleum and, therefore, revenue will naturally decline over time. As a result, E&P companies can only maintain or grow a revenue base by acquiring or finding new reserves.

Drilling and Service 

E&P companies do not usually own their own drilling equipment or employ drilling rig staff. Instead, they hire contract drilling companies like Grey Wolf Inc. or Nabors Industries Ltd. to drill wells for them. Contract drilling companies generally make a living based on the amount of time they work for the E&P companies. Drilling companies do not generate revenue in a way that is tied directly to oil and gas production as is the case of E&P companies.

Once a well is drilled, there are many activities involved with generating and maintaining its production over time. These activities, such as well logging, cementing, casing, perforating, fracturing and maintenance are collectively referred to as well servicing. As is the case for drilling, there are many public companies, like Halliburton Company and Schlumberger, that are involved with well-service activity. Revenue of service companies is tied to the level of activity in the oil and gas industry, sometimes measured by the "rig count" or the number of rigs working in the United States at any given point in time.

Conclusion

Investing in energy stocks can be complicated business. As is the case for most company analysis, a good starting point is to understand how the businesses derive revenue. For E&P companies, investors should strive to understand production and the production potential tied to current and planned exploration activity. For drilling and service companies, investors should develop a feel for the energy cycle, the drilling and service companies' competitive landscape and the omnipresent impact of oil and gas price changes over time.      

To learn more about investing in oil and gas, see Fueling Futures In The Energy Market.

by Bryn Harman, CFA

Bryn Harman, CFA, is a seasoned investment professional with more than 13 years of experience in the fields of corporate finance and investment finance. For the past seven years, his focus has been on bottom-up fundamental analysis of small cap companies. Harman is currently the director of research for a value-oriented investment firm in the Northwest. Bryn has a Bachelor of Commerce from the University of Saskatchewan, Canada.

Read more: http://www.investopedia.com/articles/07/oil_gas.asp#ixzz1hcf3wjiM