Crude oil and natural gas are the most traded commodities in the world. Hence providers of such commodities are crucial for the global economy where almost every industry needs oil and gas to operate. If purchased at the right timing, stocks of oil and natural gas industry could make you extremely rich.
However, there is a life lesson: the higher the potential return, the higher the risk. But why is this most in-demand commodity so volatile? What are the things to consider when analyzing oil and gas industry stock for investments? The visual content summarizes how to analyze oil and gas company for investment, taking the industry’s nature into consideration.
Political Factors Affect Oil Price
Unlike many of other commodities, geopolitical factors can largely affect the oil and gas industry because not every country produces this highly-sought-after commodity. In fact, many of the top producers have complicated relationships with the United States, the largest producer and consumer of oil and gas being the world’s hegemon. Therefore an elevation of political turmoil in oil-producing countries could fuel the risk of disruptions in the global oil supply, thereby the global economy. In response to political climate and global events, the oil and gas stock prices fluctuate.
Unpredictable Exploration Makes Investment Analysis Hard
In addition to its political risk components, exploration of petroleum and natural gas is highly unpredictable in nature. Before finally reaching the production phase, companies typically go through four steps: 1) taking an initial interest, 2) taking a lease or purchasing the mineral rights, 3) conducting a geophysical survey, and 4) drilling in search of oil/gas. These processes may or may not result in production. The companies consider several factors even before drilling, such as cost effectiveness, impact on environment, or simply availability of necessary equipment for drilling itself is a huge investment for the company. After drilling, it may turn out that the well is not productive without sufficient quantity of oil or gas. Hence oil and gas production is by nature unpredictable.
Oil Prices Move Cyclically
Our previous infographic “How Oil Prices Changed During Different Crisis?” graphed the changes in oil prices since the beginning of the modern oil industry. As we can see, the oil prices have been subject to boom and bust cycles. This behavior won’t be any different in future because it is a function of the capital intensity of the industry.
In other words, supply-demand imbalance creates the following cyclical behavior. Excess oil supply pushes down the price while lower price stimulates higher demand. If demand grows faster than supply, prices began to rise. Oil/gas companies began to invest in new projects, using the money they earned from the higher price. In the meantime, higher prices put down the demand. With new production starting, supply begins to outpace demand, which pushes down the price again. Then the cycle completes and resumes another.
The Primary Rule: the Larger the Company, the Less the Risk
Given these conditions around oil and gas producers, the size of the company is one of the most important parameters to follow. Generally speaking, the larger the company, the more stable it is. The chart above shows the stock prices of Saudi Aramco and Nine Energy Service for the past one year. Saudi Aramco is one of the largest and most lucrative oil companies in the world. And Nine Energy Service is an American nano-cap company. As is obvious, the stock prices of Saudi Aramco is so much more stable than the other. Surprisingly, the percentage change in Nine Energy Service’s stock prices even hit 35% in December 2020. That is to say, one could make more money but with the risk of losing more.
The size matters as a general rule. However, other factors also play a role in determining company’s positioning in the stock market. These factors include the company’s success rate in drilling and leasing/purchasing locations because the process is a huge investment for the company as mentioned above. Additionally, keeping a close eye on political and economic situation of the producing country is equally important. Needless to say, general analysis you would do for any industry stock, such as looking at 5-year yields, price/earnings ratio, balance sheets, trends etc., are also helpful.
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