The Ultimate Guide to Investing in Oil and Gas Companies: Part 1

oil and gas investing

A two-part series, our ultimate guide to investing in oil and gas companies is designed to build a comprehensive sector blueprint to facilitate money-making ideas in the sector. In this article, we explore the value chain of the industry, key players and themes that investors should know. Finally, we look at valuation techniques employed in this industry and how investors can use them effectively.

We recently wrote an article about investing in oil as an asset class (highly recommend you check it out, if you haven’t already done so). This series differs in the sense that the focus is on oil-related stocks.

Table of Contents
    Add a header to begin generating the table of contents

    What are the characteristics of the oil and gas industry?

    Investing in this sector is akin to a buffet-style (not Buffett!) restaurant. Investors can align their investments and risk appetite accordingly, while still gaining exposure in the oil and gas market. This is made possible as of the three key segments in its value chain: upstream, midstream and downstream.

    The sector’s outlook continues to be challenged, in particular, with the added pressure from the COVID-19 crisis. Evidently, the S&P Oil and Gas combined market cap has fallen from 10% a decade ago to less than 4% of S&P today. Obviously, the exponential growth of tech companies also played a part.

    What is crude oil, natural gas and shale oil?

    Crude oil and natural gas are fossil fuels made up of hydrocarbons. Accordingly, crude oil can be refined into various petroleum products such as gasoline and diesel. On the other hand, natural gas are used for heating and power generation. These are known as conventional associated oil and gas.

    oil and gas extraction
    Source: EIA and USGS.

    Shale oil, also known as unconventional oil, utilises hydraulic fracturing or fracking for extraction. For this reason, shale’s cost of production is significantly higher than conventional oil. A substitute to crude oil and largely produced in the US, shale’s rise to prominence has been driven by the “US Shale Revolution”. Consequently, reducing US' dependence on oil imports.

    Who are the key players in the oil and gas industry?

    OPEC

    The Organization of the Petroleum Exporting Countries (OPEC) is a 13-nation body that aims to coordinate and unify petroleum policies of its members. Consequently, the goal of OPEC is to ensure stabilisation of the oil markets through coordinated oil production levels among members.

    The latest data shows that, 79.4% of the world’s proven oil reserves are located in OPEC Member Countries. As a result, OPEC stands as the most important supply-side influence in the oil and global energy market.

    Largest producers and consumers of oil

    largest oil producers 2019
    Source: US Energy Information Administration (EIA). Oil includes crude oil, all other petroleum liquids, and biofuels.
    largest oil consumers 2017
    Source: US Energy Information Administration (EIA). Oil includes crude oil, all other petroleum liquids, and biofuels.

    Largest producers and consumers of natural gas

    Largest natural gas producers
    Source: BP Statistical Review of World Energy 2018
    largest natural gas consumers
    Source: BP Statistical Review of World Energy 2018

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    How does the oil and gas industry work?

    In a nutshell, the industry finds, extracts valuable things from ground, refines and sells.

    oil and gas value chain
    The oil and gas value chain.

    Upstream companies are capital-intensive businesses associated with wide margin of uncertainty. Furthermore, exploration activity may lack the commercial quantities needed to even cover costs. For this reason, it is intuitive to see why the upstream companies carry the highest risks.

    What are the key drivers of the sector?

    Oil prices is the single driving force of the sector. Despite the push towards renewables, the dependence on oil and gas remains significant. For example, oil prices alone drives ~50-60% of the cash flow for oil majors in recent years.

    Furthermore, the cyclical nature of the industry means that it's highly sensitive supply-demand fluctuations. We highlight the three key variables in the industry.

    • Demand: Global growth, economic activity and substitutes such as shale oil or renewable energy.
    • Supply: This has to do with how much oil is available. This is largely driven by OPEC members, although the influence has been somewhat reduced thanks to shale oil revolution from US shale producers.
    • Geopolitics: Also known as petroleum politics. This affects both supply and demand. For example, whenever there’s a crisis in an oil producing country, oil prices tend to shoot up out caused by fear of decreased supply.

    Finally, external factors such as decarbonisation, environmental, social and corporate governance (ESG) investing and tax incentives for renewable energy can also have direct impact on its supply and demand.

    What are the current themes?

    Energy transition

    Energy transition describes the shift from oil and gas to renewables and alternative sources. Recent years saw the shift and growth in investments into renewables by integrated oil companies. While this may seem to pose an existential crisis to the incumbents, oil and gas will continue to play a significant role in the industry. Despite active decarbonisation initiatives, including carbon pricing and the EU’s Emission Trading Scheme, renewables investments remains <1% of European oil majors in 2019.

    The rise and fall of US shale

    Over the past decade, US oil and gas output has surged by >50%, largely thanks to its shale oil production. Consequently, US is able to reduce its reliance to global oil and gas prices and more importantly, decisions taken by OPEC.

    In fact, OPEC’s unsuccessful attempt to drive US shale industry out of business by oversupplying the market, caused a one of the largest crash in the oil market in 2014.

    While the incident managed to put some out of business, innovation led to reduce production cost for the shale oil industry. Even so, it's said that US shale is economically unviable when Brent crude falls below $50 per barrel.

    The pandemic-induced oil price crash has only made matters worse for the shale industry. Consequently, Whiting (WLL) became the industry’s first victim by filing Chapter 11 in early April.

    Consolidation / M&A

    The sector has traditionally been active in mergers & acquisition (M&A). Currently, there are few key factors driving this.

    Firstly, energy transition. The pivot towards renewables can be achieve more swiftly via divestments of oil and gas assets and/or acquisitions of renewables/power assets.

    Secondly, continued pressure on production costs. With global oil prices at a depressed level, it’s difficult to see how small/medium size firms can withstand its current production costs. Vertical integrations may prove useful to protect margins.

    Lastly, the Russia-Saudi oil-price war and the demand shock from the coronavirus, both point towards a new wave of M&A in the sector. More importantly, should oil prices persist at the current levels, the industry will have to consolidate to survive.

    How to value oil and gas companies?

    Industry specific accounting methods

    Before we jump into how to appraise oil and gas companies, it's key to appreciate the differences of the two industry-specific accounting methods.

    Applicable primarily to exploration and production companies, they can choose between two accounting methods when recognising costs: successful-efforts (SE) or full-cost (FC) accounting. The choice between both affects its cashflow and income statement.

    As you might have already guess, this is merely an accounting presentations and has no bearing on the actual cash position. However, it can be useful to know when comparing valuation metrics across companies using different methods.

    SE allows companies to capitalise only for expenses related to successful exploration and development. To the contrary, any unsuccessful exploration will result in immediate expense recognition in its financial statements.

    On the other hand, FC allows companies to capitalise all exploration expenses whether or not it is deemed successful.

    successful efforts full cost oil and gas accounting
    A simplistic example highlighting the differences of the two methods.

    Highlighting the obvious, SE is a conservative approach as it accelerates expense recognition. In other words, a company using the SE method would look more expensive today.

    Commonly used valuation metrics

    P/E ratio: As with most sector, P/E can be a useful measure comparing companies. In this particular case, it’s less helpful in a cyclical sector where companies may be loss making during the down cycles.

    EV/EBITDA: The enterprise multiple is more useful as it takes into account the balance sheet differences and used more widely to compare loss making companies with negative earnings.

    FCF yield: A cash metric, FCF yield provides an idea of a company’s operating liquidity and capital expenditures. While this measure may be negative in down cycles, it’s still useful to see the trajectory of future cash flows.

    Dividend yield: Similar issue to P/E ratio, this measure is only helpful during a more stable period in the cycle, where capital return story is the overriding driver.

    Other valuation methods such as sum-of-the-parts (SoTP) and discounted cash flow (DCF) methodology can be useful as well. We look to cover that specifically in future articles.

    This concludes the first part of our simple but comprehensive guide on investing this sector. If you would like to learn more, check out our recent article about investing in oil.

    In the next part, we’ll examine the driving forces of the key segments within the oil and gas industry.

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