Oil Stocks

For a long time having exposure to oil was a no-brainer for any investor. From air travel and commuting to heating our homes and powering factories, oil truly powered the world.

And oil and its derivative products (e.g. gasoline) still does to a great extent. However, the fallout of the novel coronavirus may have begun a process in which the impact of oil on global markets is becoming less and less. That’s because renewable energy sources were already becoming cost-competitive with oil, and that price gap is lessening as time goes on.

Nevertheless, the world will still be using fossil fuels for the near future. And that means that oil stocks belong in your portfolio. Oil stocks contain less risk than trying to buy and sell oil on the options or futures markets. And most oil stocks pay a dividend which gives investors a predictable income stream that can make up for the volatility that is inherent in these stocks.

Introduction

The most important thing to remember about investing in oil stocks is that your investment is fundamentally driven by supply and demand. Simply put when demand for crude oil is high, prices go up. Conversely when demand decreases, so do prices.

For decades, particularly since World War II, the demand for oil was high. Many nations were building a new infrastructure of roads and bridges. Air travel was making the world smaller and businesses became truly international. And powering all of it was oil.

You can invest in oil by trading the commodity directly by trading options in the futures market. Some investors will also choose to invest in an exchange-traded fund (ETF) that is tied to the price of oil or includes a basket of companies with exposure to the oil sector.

However, a more indirect (and slightly less risky) way to play the oil market is to buy oil stocks. An oil stock can cover many areas of oil production. In this article, we’ll review why you should consider investing in oil; we’ll review your investment options, and more directly the different types of oil companies that you can invest in.   

Why should you invest in oil today?

The pandemic brought on by the novel coronavirus has been devastating for the oil and gas sector. As we mentioned above, this is a supply and demand business. And the first hint that the virus was worse than we thought was when oil futures began falling in February.

This is an important thing to know about investing in oil. Oil has been a reliable indicator of economic activity. When analysts and institutional investors forecast decreasing demand for oil, they bid down the price of crude oil. This in turn affects oil stocks which as we said tend to move with the market.

Due to the severe demand restriction during the pandemic, several oil companies have gone bankrupt. And the share price of most oil stocks has fallen dramatically. And when the notion of a “V-shaped” recovery did not materialize, it has put further pressure on oil prices.

Nevertheless, despite several near-term headwinds, oil will remain a worthwhile investment. And oil stocks can be a way for risk-averse investors to have exposure to the oil sector without dabbling in the commodities market.

The basics of oil production

Oil is expensive to bring to market. It’s more than just the cost of extracting it from the ground. Oil has to be transported, stored, and in many cases refined into gasoline or other products. And those costs are usually fixed.

This is a double-edged sword for the oil companies. When a barrel of oil sells for more than the sum of all these costs, oil companies turn a profit. And stocks of oil companies will go up as well.

However, the opposite is also true. When oil sells for less than, many of these companies will lose money. During these times, stocks of oil companies will go down.

Why buy oil stocks?

Although oil stocks generally move in concert with the price of a barrel of crude, the correlation is not always exact. For example, many oil companies will talk of a “break-even” point. This can allow the price of crude to fall a little while these companies can still be profitable. This makes oil stocks a slightly less risky option than trading oil in the options or futures market.

But perhaps the most important reason to own oil stocks is that many oil stocks pay a dividend. For example, prior to the pandemic some oil companies had increased their dividends for decades. These companies know that preserving its dividends has to be a priority because of the volatility associated with the underlying price of oil.

However, it’s important that you focus less on a company’s dividend yield (which can move up or down with the share price), but also on how the yield compares to the company’s free cash flow (FCF). In general, investors want to find companies that can pay their entire dividend obligation out of its FCF. This “payout ratio” should be at least 1.1.

Different types of oil stocks

Investing in oil stocks would be easier if all oil companies were affected in the same way by rising or falling crude prices. But, in fact, the oil sector is very diverse and each sector may be affected slightly differently by rising or falling oil prices.

Here is a brief description of different kinds of oil stocks:

• Upstream companies – These are the companies investors most frequently think about as an oil stock. These companies are involved in exploration and production. As the name implies, this means these companies explore locations looking for oil. When they find a promising location, they drill wells to extract the oil. However as you might imagine, these companies are affected most by changes in the price of crude oil. The largest upstream company in the United States is ConocoPhillips (NYSE:COP).
  
  
• Midstream companies – These companies transport crude oil through pipelines that is then stored in terminals that they own. The oil stays there until it is sent to be refined or exported. Some of these companies will even transport the newly refined company through its own pipeline networks. Midstream companies are slightly more insulated from oil price fluctuations because they usually operate on long-term contracts with fixed terms. One of the leading midstream companies is Enterprise Products Partners (NYSE:EPD). A unique aspect of EPD stock is that the company is a master limited partnership. This has tax advantages for individual shareholders but can increase the risk of larger losses.
  
  
• Downstream companies – These companies refine oil into other products such as gasoline and petrochemicals. In many cases, these companies are also part of selling this refined product to consumers. Two examples of downstream companies are gas station operators and refinery operators. Although these companies are not directly affected by a drop in crude prices, their stock still tend to fall when oil prices fall. One of the major downstream companies is Phillips 66 (NYSE:PSX).
  
  
• Integrated companies – These companies do business in more than one of the fields mentioned above. When you hear a reference to “Big Oil” companies, it is a reference to companies such as ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) that have large upstream and downstream operations with some midstream business.
  
  
• Oilfield services companies – Another way to invest in oil stocks is through the companies that provide equipment, operational support, and logistics to other oil companies, typically upstream companies. Oilfield services companies are hurt when oil prices fall because one of the first things upstream companies will do is cut their service costs.

ETFs are a different way to play oil stocks

The easiest and more popular way to invest in oil stocks is to buy stocks of individual companies. However, investing in exchange-traded funds (ETFs) can be a smart way to manage the risk of this sector. An oil ETF allows investors to invest in one or more of the sectors listed above at one time. For example, the SPDR Oil and Gas Exploration & Production ETF (NYSEARCA: XOP) tracks the upstream sector.

The final word about investing in oil stocks

Oil stocks have been battered in 2020. But the near-term outlook for oil makes oil stocks an attractive investment opportunity. The fortunes of oil companies are impacted to a greater or lesser extend to the price of crude oil. And that’s why it’s important for investors to understand what subsector of the oil industry the company they are interested in investing in is engaged in.

However the benefit of having multiple options is that investors have many options including buying shares of ETFs that add even more diversity.