Investing In The Oil And Gas Industry In Good Times And Bad

21 mins

Investing In The Oil And Gas Industry In Good Times And Bad

Energy To Burn

The energy industry has experienced some of the biggest changes in its entire history over the past decade – and the phrase “peak oil” proves that very point.

“Peak oil” used to refer to peak oil supply: a theoretical point in the future when we’d hit the maximum rate of production, and after which reserves would slowly start running dry. Some doomsayers (probably fans of the 1995 Kevin Costner movie Waterworld) even predicted miles-long queues at gas pumps, spiraling inflation, and global oil-based conflict…

Fast forward to today, and “peak oil” is used in precisely the opposite sense: referring to peak oil demand. And that’s because two major trends have completely transformed the energy industry in the meantime.

First, the shale revolution in the US – which saw the country become the largest oil producer in the world – unlocked a massive amount of oil that experts previously thought was too expensive to extract. That helped reassure people the planet wasn’t going to run out any time soon.

Second, the cost of renewable energy plummeted thanks to greater innovation and scale, helping reduce the world’s reliance on traditional fossil fuels to meet its energy needs. Even electric vehicles (EVs) have begun to go mainstream as prices come down and regulators enforce cleaner air standards, displacing the need for gasoline – the single biggest use of oil.️

Today, the consensus is that it’s a matter of when – and not if – renewable energy and EVs overtake traditional fossil fuels and petroleum-powered vehicles. Somewhere around that point or soon afterward, oil demand will start to fall. And that’s when we’ll have reached that historic milestone: “peak oil” Mark II.

So does that mean traditional energy producers are destined for the scrap heap – and unworthy of your hard-earned bucks’ investment? Not necessarily. For starters, no one – not even so-called energy experts – really knows when oil demand will peak. It could be within the next decade, or it could be in 40 years’ time. Until then, oil and gas producers could still churn out healthy profits and distribute them to their shareholders. What’s more, energy “supermajors” – massive companies who cover the entire “value chain” – are no fools: pivoting their businesses towards cleaner energy sources such as natural gas or renewables may see them not only survive but thrive.

Another reason not to shun the energy sector is its breadth: there are investable companies specializing in all points of the value chain that you can target depending on your view. For example, if you think we’re imminently headed for a massive supply glut that’ll cause oil prices to fall, you might want to invest in refineries that convert crude oil into usable end products: they’d benefit from the lower cost of their raw material.

This is probably a good time to explain the four key parts of that energy value chain. The upstream industry looks for reserves and extracts oil and gas once they’re found, while the downstream industry converts them into usable products such as fuel, plastic, and petrochemicals. The midstream industry, meanwhile, links the two together, storing and transporting oil and gas across networks of pipelines railroads, trucks, and ships. It also transports finished products to end-users: the gas, for example, that heats people’s homes. And finally, there’s the oilfield services industry: providing equipment and services that help upstream companies explore for and extract oil and gas.

It’s important to note from the outset that energy is essentially a commodity industry. There may be different grades of crude oil, sure, but they’re largely interchangeable, and natural gas is pretty much the same worldwide. The same goes for the end products produced downstream: gasoline at the pump is pretty much the same wherever you are (well, except Brunei).

The most important things you need to understand when investing in any commodity industry are typically supply, demand, and anything else determining that commodity’s price. And that’s exactly what we’re going to do across the remainder of this Pack. We’ll go over the biggest supply and demand trends impacting the industry globally – discuss how oil and gas prices are determined in the short run and over the long term – and conclude by laying out the different ways you can invest in the oil and gas industry.

A brief note before we begin: here at Finimize, we’re a forward-thinking lot – and we care about the future of our planet. You, our readers, asked us for a Pack on oil and gas; and here it is. Plus, as mentioned, the energy giants of the past are likely to number among the energy giants of the future – and it’d be wrong to ignore that. Disclaimer out of the way, let’s get cracking.

The takeaway: The energy industry includes upstream, midstream, downstream, and oilfield services branches. And while it’s undergoing some profound changes, it’s still an investment worth considering.

Shifting Supplies

In 1859, American businessman Edwin Drake used a steam engine to drill a hole in remote Pennsylvania – now recognized as the world’s first modern commercial oil well. Its immediate success sparked a major oil boom in the US – and even today, such conventional “onshore” drilling remains the most common method of global oil production and its largest source of supply.

Conventional drilling involves a vertical well piercing an oil reservoir and pumping its contents up to the surface. And onshore drilling denotes production on land, as opposed to “offshore” drilling beneath the seabed. Because of its relative simplicity, this combination remains the cheapest way to produce oil – and these types of producers tend to feel the least pain during periods of weak oil prices. But that hasn’t stopped the Organization of the Petroleum Exporting Countries (OPEC) – the largest source of onshore oil production globally – from regularly intervening to help prop up the oil price.

OPEC consists of 14 oil-producing countries, predominantly in the Middle East and Africa, that collectively supply almost a third of the world’s oil. The group was set up in 1960 to coordinate the oil policies of its members and remains one of the most influential forces in the global oil market. For example, OPEC has historically implemented production cuts when it deems oil prices are too low in order to restrict supply and drive prices back up. While these countries’ drilling operations’ are still profitable during periods of weak prices, oil funds the bulk of their governments’ spending on infrastructure, healthcare, defense, and so on. They, therefore, rely on higher oil prices to balance their budgets and break even.

Despite roping other major producers including Russia into related “OPEC+” agreements in recent years, the group’s share of global production shrank from 35% to 30% as the shale revolution in the US took off. Over the past decade, US oil and gas production has surged almost 60% – and the country is now the largest oil producer in the world. In fact, oil from US shale now makes up almost 10% of global supply. Forecasts of future growth are less certain, depending as they do on future oil prices – but the chart below gives several analysts’ views on the direction of travel.

US oil production forecast
Source: Rystad Energy

Compared to conventional drilling, producing oil from deep shale rock deposits is a lot more complicated. Hydraulic fracturing, or “fracking”, involves drilling a hole downwards and then horizontally – sometimes for over two miles – to access thin layers of shale. A mixture of water, sand, and chemicals is then pumped into the well at high pressure in order to cause cracks in the rock, allowing the trapped oil to flow up to the surface.

If that all sounds more convoluted and expensive than conventional vertical drilling, that’s because it is. But thanks to some good ol’ American ingenuity and innovation, costs have gone down significantly in recent years. Today, the break-even price for US shale producers drilling new wells sits at around $50 a barrel. That’s lower than the break-even price for new offshore projects – which isn’t great for large offshore oil producers like Norway and the UK.

The reason new project viability is so important is that drillers have to constantly track down and tap up new oil reserves to offset depleting production from existing ones. Today, however, more and more energy producers are starting to shift their focus to exploring for and exploiting natural gas instead. Natural gas is produced in virtually the same way as oil – either through conventional drilling or methods such as fracking – and can also be found onshore and offshore. The US shale revolution has also seen the country become the largest natural gas producer in the world, closely followed by Russia – with the two countries together representing almost 40% of the world’s total natural gas production.

So why the increasing shift towards natural gas? Because it plays a key role in the global energy transition. We already talked about “peak oil” and how demand will eventually start to decline. But our energy needs still have to be met somehow – and the consensus is that a combination of natural gas and renewables is the immediate way forward. We’ll address this further, so stick around...

The takeaway: OPEC, the world’s most influential oil-producing body, has been losing market share to US shale. But natural gas, produced in much the same way as oil, may be the next big battleground.

Developing Demand

Oil and gas demand is generally linked to economic growth. When times are good, companies expand and people spend, and everyone needs more energy. And when the economy slows down, demand drops. But if you’re considering investing in the oil and gas sector, you’ll need to do better than generalizations. So what are the biggest uses of oil and gas, and what are their respective outlooks?

When oil goes through the downstream process, it’s refined into different usable products – and the two most important are gasoline and diesel. Both of these are principally transport fuels (with diesel also used for heating); together, they represent over half of oil demand, making transportation the single most important factor in the demand equation. The second-largest use of oil, meanwhile, is as a “feedstock” for the petrochemical industry – with oil converted into plastic, rubber, and even food ingredients.

Natural gas is also used as a feedstock for the petrochemical industry. In fact, it can be used somewhat interchangeably with oil, and petrochemical companies often make a choice based on availability and economics (i.e. which is cheaper) along with other factors. But this represents only a fraction of natural gas demand.

The single largest use of natural gas is electricity generation, closely followed by heating in residential and commercial buildings. Together, that represents around two-thirds of global gas demand. Other uses exist in the industrial sector – where natural gas acts as a heat source in the manufacture of fabrics, glass, steel, and so on – and in the creation of agricultural fertilizers.

So what’s the outlook for all these demand drivers? With threats emerging on all fronts, it’s not the rosiest of pictures. For oil – where demand is heavily concentrated in transport fuels – electric vehicles (EVs) are increasingly displacing the need for gasoline and diesel. EV adoption is on the rise because the cost to buy and operate one is falling, and because governments around the globe are enforcing stricter air quality standards for road users. In fact, 17 countries have so far either imposed some kind of restriction on old-school internal combustion engine cars or set EV targets.

According to one study by a prominent research group, 57% of new car sales in 2040 will be electric – and over 30% of the global vehicle fleet will consist of EVs. That would mean a lot less oil demand: 14 million barrels per day, to be precise, over 10% of our current daily oil consumption. And this projection is one of the largest sources of fuel for the impending peak oil theory.

But hang on – if more people drive EVs, doesn’t that mean more electricity demand and therefore more natural gas? Well, yes and no. While electricity demand should grow, the impact on natural gas depends on where that electricity comes from. And in case you haven’t noticed, renewables are the fastest-growing source of energy right now – driven by falling costs and governments trying to tackle climate change.

Nevertheless, natural gas also has a transitional role to play here. Using natural gas to generate electricity is a lot cheaper and cleaner than burning oil or coal for the same purpose – and it also allows countries to install more renewable energy capacity, as it can quickly compensate for any dips in solar or wind power supply. That should stay true until the cost of renewable storage comes down far enough to see batteries the size of parking lots kick in when the wind isn’t blowing and the sun isn’t shining.

As for the other big components of natural gas demand – heating – that’ll most likely stay static as population growth is offset by increasing energy efficiency and electrification. The future of petrochemical demand (for both oil and gas), however, is less certain. Increasing opposition to single-use plastics and greater investment in plastic recycling may well see the need to use oil and gas in new plastic production reduced in the future.

Putting all of this together, what does it mean for oil and gas demand in the long run? Well, energy giant BP’s latest energy outlook forecasts demand for natural gas to grow at an average rate of 1.7% a year through 2040 – much higher than oil’s meager 0.3%. Both, however, pale in comparison to renewable energy’s projected annual average growth rate of 7.1%...

BP energy source share
Source: BP

The takeaway: Oil demand is largely driven by transport fuels, facing an emerging threat from EVs. And gas demand is mainly driven by the power sector – fast transitioning towards renewables, albeit with natural gas an important transitional back-up for now.

Is The Price Right?

Like most commodities, long-term oil and gas prices are determined by the sorts of supply and demand factors we’ve discussed. And these can be visualized through the chart commonly known as a “cost curve”.

A cost curve shows how much output different suppliers produce at a given cost per unit. In other words, it displays a commodity’s available supply in increasing order of cost. The width of the bars indicate supply quantity, and the height shows cost per unit. The market price of the commodity, meanwhile, is found at the point where the quantity demanded intersects the cost curve. An example is shown below.

Cost curve
Source: McKinsey

We can use a theoretical oil example to explain this further. Let’s say OPEC can produce 10 barrels of oil at a cost of $30 a barrel, US shale drillers can cough up 5 barrels at $40, and UK offshore rigs can churn out 4 barrels at $50. If oil demand is 15 barrels, then you only need OPEC (10 barrels) and US shale (5 barrels) to produce all their oil to fully meet that demand. Producers of a commodity are generally willing to supply it as long as the price exceeds their cost of production; otherwise they’ll make a loss. In this case, US shale producers need a price of at least $40 a barrel in order to produce enough to meet demand – and so the market price of oil will be around $40. If oil demand increased to 17 barrels, meanwhile, we’d need to turn to UK offshore supply – but they’ll only supply oil at $50+ a barrel. In that case, the market price would go up to $50.

Natural gas is a bit different in that it’s considered an “island commodity”. Because it’s much harder to transport unstable gas from one region to another than it is liquid oil, you can get big regional differences in the gas price based on local supply and demand dynamics. But the growing liquefied natural gas (LNG) trade – which allows cooled gas to be shipped globally – is beginning to more closely link prices around the world. If natural gas is cheap in the US and expensive in Asia, then Asian energy companies will now look to import US LNG. The increased demand for US gas will lead to higher prices there, while increased supply in Asia will reduce prices there – converging the two.

Besides supply and demand, however, there are short-term factors that influence oil and gas prices. Seasonal trends, for example: natural gas prices are usually higher in the winter when heating demand is at its highest, while oil prices tend to be higher in the summer as more people travel.

Another important short-term factor is inventory: the amount of oil or gas in storage. With natural gas, production is relatively stable throughout the year: one does not simply turn off a gas well. But to balance the mismatch of seasonal demand, natural gas is injected into the ground for storage during the summer and withdrawn when it’s needed in winter. If storage levels are too low, natural gas prices go up, incentivizing greater production – but also lower usage. These two factors combined should eventually bring inventory and prices back to normal levels.

Speculators can also influence oil and gas prices. These traders buy and sell oil and gas futures with the goal of making money from price changes – sometimes with little regard to the underlying supply and demand factors. For example, some hedge funds use a “momentum” strategy to invest in commodities: buying commodities that have gone up recently in the expectation of future price increases. So if oil has done well over the past few months, speculators will likely start buying oil futures, driving up prices.

Lastly, one of the most important short-run factors influencing oil and gas prices is geopolitics. OPEC, as mentioned, supplies almost a third of the world’s oil, and its members are mainly found in the Middle East and Africa. When tensions are simmering in the region – for example, between Saudi Arabia and Iran – both speculators and firms that actually need oil may buy oil futures for fear of future supply disruptions. A prime example of this came in September 2019, when an attack on Saudi Arabian infrastructure caused the price of oil to shoot up over 20%.

The takeaway: Oil and gas prices are determined by supply and demand factors in the long run – but seasonal trends, inventory levels, speculators' actions, and geopolitics all influence short-term prices.

Investing In Oil & Gas

OK – so now that you get the supply and demand dynamics behind the oil and gas markets and how prices are determined, how do you go about investing in the sector? The first (and most obvious) method is to invest in individual companies. Before you dive in, however, it’s worth knowing the most important drivers of a company depending on where it sits in the energy value chain ⛓

The key factors determining upstream companies’ profits are production volume, oil and gas prices, and operational efficiency. Rising prices increase all of these companies’ revenue – and upstream firms can grow this further by upping their production volume. Furthermore, the leaner and more cost-efficient a company’s drilling operations are, the more profit it can make from every dollar of sales. Still, of these three, oil and gas prices are the most important.

The most common reason for investing in upstream companies – also called exploration and production (E&P) companies – is as a bet that oil and gas prices will go up. But if they end up heading south instead, E&P companies’ stock prices can get slammed. Investing in the E&P sector is therefore risky – and should be approached with caution. (One silver lining, perhaps, is the potential to snatch up some of these companies more cheaply as an increasing number of big “institutional” investors divest from hardcore fossil-fuel stocks).

As for midstream companies that transport oil, gas, and finished products, the most important thing driving revenue is volume. The more oil and gas a midstream company moves around, the more money it’ll make because it usually gets paid on a per-unit basis. This makes midstream companies less sensitive to oil and gas prices – although higher prices obviously incentivize E&Ps to produce more, leading to higher transportation volume.

Successful investing in the midstream sector involves identifying those companies that stand to benefit from future volume growth and getting ahead of the game. Alternatively, you can invest in the sector for its income potential. Because midstream companies’ earnings are volume-driven and sometimes regulated (similar to utility companies), they’re relatively stable – and allow firms to pay investors a consistent dividend. Another successful investment strategy therefore involves finding midstream players with attractive dividend yields which can be sustainably supported by their operations. Companies that can grow their dividend are even better, natch…

Finally, downstream companies that convert raw oil and gas into usable products benefit when the “spread” widens between the cost of their inputs and the price of their outputs. For example, if oil prices are falling but gasoline shortages are driving prices up at the pumps, refineries will see their margins expand and their earnings boosted. Another key variable is the “utilization rate”, a.k.a. the percentage of time a refinery is running. A business that can maximize this – by, for example, reducing maintenance time or avoiding unplanned outages due to accidents –will make more money from its operations.

Regardless of the type of company you’re investing in, you can do so by picking individual stocks or by using exchange-traded funds (ETFs). For example, if you think oil and gas prices are headed up, you can buy an ETF tracking a basket of E&P companies (e.g. XOP) or oilfield services firms (e.g. OIH) – the latter would benefit from increased drilling activity if energy prices are higher. If you want to be more conservative, meanwhile, you can invest in diversified energy companies – big businesses “vertically integrated” across the entire energy value chain. Because of the broad nature of their operations, these companies are less sensitive to energy price movements. Still, the midstream is even less sensitive – and these firms also tend to have higher dividend yields. MLPX is an example of an ETF that tracks midstream companies.

Of course, you can also invest directly in energy commodities instead of energy companies. Why not simply buy oil if you think its price is going up, instead of buying E&P companies and introducing a bunch of other variables into the equation? You can indeed invest in oil and gas through futures contracts – but you need to proceed with great caution, due to the inherent leverage involved futures – and because oil and gas prices tend to experience big moves fairly frequently.

Alternatively, you can invest in an oil ETF (e.g. USO) or natural gas ETF (e.g. USG). But be warned: these don’t perfectly track oil and gas prices, thanks to fees and the fact they too invest in futures contracts rather than the physical commodity. And since futures contracts have expiry dates, these ETFs have to constantly reinvest funds into newer ones. This constant “rolling” of futures means the ETF’s performance will deviate from the underlying energy commodity.

And that’s that: now you know all about the energy industry, you can roll out the barrel and get involved. Let us know how you get on!

In this Pack, you’ve learned:

🔹 The energy industry includes upstream, midstream, downstream, and oilfield services branches. And while it’s undergoing some profound changes, it’s still an investment worth considering.

🔹 OPEC, the world’s most influential oil-producing body, has been losing market share to US shale. But natural gas, produced in much the same way as oil, may be the next big battleground.

🔹 Oil demand is largely driven by transport fuels, facing an emerging threat from EVs. And gas demand is mainly driven by the power sector – fast transitioning towards renewables, albeit with natural gas an important transitional back-up for now.

🔹 Oil and gas prices are determined by supply and demand factors in the long run – but seasonal trends, inventory levels, speculators' actions, and geopolitics all influence short-term prices.

🔹 You can invest in individual companies at different points of the value chain, or in ETFs that track groups of those companies. Alternatively, you can invest more directly in oil and gas through futures or ETFs – but you should do so with great caution.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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