How to Invest in Oil Wells & Gas – Investment Opportunities

By : Jason Van Steenwyk

Oil makes the world go round, and there’s no sign of that changing any time soon. Petroleum remains in high demand, as it is an efficient way to generate both BTUs (British Thermal Units, a measure of energy) and kilowatt hours. Petroleum also has a multitude of uses in industry, as it can be used as a lubricant and is a key component in the creation of plastics.

Natural gas, for its part, is a popular source of heating and cooking energy. It can also be converted into diesel fuel and electricity, and is essential in the creation of chemical fertilizers.

While crude oil prices and gasoline prices are relatively high compared to historic norms, when adjusted for inflation, natural gas prices are currently near a 10-year low, as of early 2012. This creates a natural possible buying point if demand for natural gas should increase – or if supply should fall – resulting in a price increase.

Ways to Invest

You can approach oil and gas investing in a number of different ways. For example, you can consider the industry a collection of companies providing products or services to consumers, as well as to other players in the oil and gas industry itself.

You can also approach the industry as a commodity, and seek to profit from changes in the prices of crude oil, gasoline, diesel, and other products.

1. Mutual Funds or ETFs
Alternatively, you can buy shares in a number of oil and gas-focused mutual funds or ETFs. These help you gain substantial exposure to the commodity without taking direct risk in commodity spot prices and without tying too much of your fortune to the prospects of any one company.

2. Large Cap Stock or ADRs
These are two methods to gain exposure to the oil and gas markets, both via publicly traded companies – the most obvious being Exxon-Mobile (NYSE: XOM), one of the largest companies in the world, as measured by market capitalization. You can also buy stock in other companies such as British Petroleum, PetroChina, Chevron, ConocoPhilips, Marathon Oil, Royal Dutch Shell, Gazprom, the Anadarko Petroleum Corporation, and many others. Each of these companies engages in oil exploration, and you can buy direct exposure to them simply by buying shares or ADRs(American Depositary Receipts) through your broker.

3. Futures Contracts
You can purchase derivatives such as oil and gasoline futures contracts; these, however, can be risky, since futures contracts can and do frequently expire without any worth.

4. Small or Micro-cap Stock and Limited Partnerships
If you want to take a more direct equity position in a smaller company or project, you may consider making a play further down the oil and gas industry “food chain” into a small or micro-cap stock, or even a limited partnership that focuses on oil and gas. This is a more specialized field of investing, and if the business is not publicly traded, you will typically need to engage the services of a broker who specializes in this industry for access to these kinds of businesses. Or if you have a significant amount you can invest, you can deal with the company’s management directly for a private placement opportunity.

Types of Oil and Gas Investments

Broadly speaking, there are four kinds of oil and gas investments:

1. Exploration
These companies or projects buy or lease land and invest money in drilling. If they strike oil, the investment can pay off 10 times over – sometimes much more if the company uses borrowed money (leverage) to finance operations. If not, they may lose nearly everything they invested in that particular project. Pure exploration companies are best suited for those with very high tolerance for investment risk. These plays are highly speculative.

2. Developing
These projects drill near proven reserves, hoping to unlock further value. These are somewhat less speculative, but there are never any guarantees that their efforts on any one plot of land will bear fruit.

3. Income
These projects involve the acquisition of plots of land, either through lease or purchase, over proven oil and gas reserves, and seek to create a steady stream of income over and above expenses. This is generally the safest way to get involved specifically in the drilling and extraction operations, and is more of an income play than a speculative play. The risk is that the oil or natural gas will run out faster than expected.

This investment is for those seeking a passive income stream, but who can take on more risk than those investing in other traditional income generators, like investment grade bonds and annuities.

4. Services and Support
These companies provide a nearly unlimited menu of supporting services to the oil and gas industry. Examples include transportation, shipping and logistics companies, pipeline companies, construction and rigging companies, drilling and refining hardware and equipment manufacturers, refiners, and many others.

Investing in these companies is similar to investing in any other company involved in B2B services, logistics, technology, and the like. Some of these investments don’t rely on increasing fuel prices to be profitable. For example, pipelines make money by charging a fee per barrel transported. They’ll make roughly the same amount regardless of whether fuel prices rise or fall, as long as demand remains consistent.

Pros & Cons of Oil and Gas Investment

Advantages

1. Diversification. Oil and gas investments have historically provided a useful diversifier against the overall economy. When gas prices rise, economies tend to slow. This could cause the rest of your stocks and funds to stumble. But when oil and gas prices rise, oil and gas stocks tend to rise with them. An exposure to oil and gas stocks can help insulate your portfolio against economic slowdowns caused by oil shocks.
2. Profit Potential. Investments in the smaller companies and limited partnerships can occasionally pay off big. A single well can generate many times its costs if drillers strike oil, and the well can pay dividends for many years.
3. Tax Advantages. There are some tax advantages to oil and gas investing. For instance, the IRS allows companies to deduct for depletion – an allowance similar to that for depreciation in rental real estate, which is a way of accounting for the gradual exhaustion of mineral supplies in a given plot of hand. If you buy shares in a publicly traded stock, this benefit will be largely invisible to you, since publicly traded stocks are C-corporations and don’t pass their gains and losses to shareholder tax returns. However, if you buy a membership in a limited partnership, this could be a very important consideration. Depletion could be the difference between a property that’s cash flow positive and one that loses money.

Disadvantages

1. Volatility. Oil and gas investments can be subject to wild price swings – especially when investing in smaller companies. If you get involved in exploratory (or “wildcatting”) drilling projects, you can easily lose a great amount of money. Diversification is the key to oil and gas investing. Losses of 50% or more are not unusual, and you can lose everything on any project.
2. Liquidity. While you can usually quickly sell shares in larger companies, you may have a hard time finding a buyer for shares of smaller companies. In some cases, you may have to redeem your interest with the company or limited partner directly. This is frequently the case with closely held, non-publicly traded companies and limited partnerships. Don’t become involved in these unless you are willing to tie up your money for a while.
3. Commissions. When you buy into a limited partnership or closely held corporation, you will typically pay a commission to a broker or intermediary. These commissions tend to be much larger than standard stockbroker commissions, and can exceed 20% for very illiquid companies. Any money that goes to a broker is money that doesn’t get put to work for you.
4. Complexity. Interests in closely held companies, oil wells, and other ultra-micro-cap oil and gas projects aren’t for everyone. There are special tax rules that govern oil, gas, and mineral investments, and there are rules specific to limited partnerships that may affect you – especially as you file taxes or account for shares when you sell them. I don’t recommend limited partnerships or MLPs (master limited partnerships, which are limited partnerships that are publicly traded) except to very experienced investors who are in a position to take risks and have money committed for a long period of time. In a pinch, however, you may have better luck selling shares in an MLP than in a non-publicly traded limited partnership.

A Note of Caution

While many limited partnership opportunities are legitimate, the industry also has its share of scammers. Beware of anyone who tells you an investment “can’t miss,” who promises big returns with no risk, or that an investment is only available to a favored few. And never buy into a limited partnership or purchase a share of stock over the phone.

At the very least, get a prospectus and do your own due diligence. Get your own independent financial advisors who have experience in the industry and do not have a vested interest in whether you invest.

Final Word

Oil and gas are volatile. When you become involved in these ventures, have a healthy respect for the potential risks and be honest with yourself about your own risk tolerance and investment horizons.

Are you a natural entrepreneur, with lengthy horizons? Can you afford to lose substantially on any one venture? Is it worth the risk if there’s a chance at large gains? You may be a candidate for limited partnerships, futures, or shares in small exploration companies. If they strike it rich, so will you. But you could lose it all.

If you don’t have ice water in your veins, though, you may want to stick to more conventional plays: shares in big companies like ExxonMobil and Halliburton, for example, or mutual funds that focus on oil and gas.

Also pay heed to liquidity. If there is any chance at all you will need to pull your money out in a hurry, the limited partnership route is not for you. These investments can be lucrative, but they work best for those who are able to lock up their funds for years at a stretch.