Want to Invest in Oil? Know What You are Buying

I had a conversation with a friend recently about investing in oil. It went a little something like this.

Friend: "I'm thinking about investing in oil."

Me: "OK, what kind of oil company?"

Friend: "Well, domestic prices are increasing and takeaway capacity is improving across the country, so I think it's a good time to be in the exploration and production space."

Me: "OK, what kind of exploration and production company?"

Friend: "Huh?"

Just as there are different parts of the entire oil industry, there are several different types of exploration and production companies, and the distinctions go much further than just market cap. Let's take a look at the different types of exploration and production companies so you can determine what is best for your portfolio.

Source: Chesapeake Energy media relations.

For the inner wildcatter in all of us
The shale boom in the United States has created a new gold-rush type attitude for many domestic players. As we learn more about the potential of shale resources, we are finding that some regions are more geared for rapid growth. Two of the most prominent players that have exemplified this movement are Kodiak Oil and Gas (NYSE: KOG  ) and Continental Resources (NYSE: CLR  ) . Both have made their mark as companies that have worked almost exclusively in the Bakken formation in the U.S., and their early entry has translated into rapid growth. 

Company Compounded Annual Growth Rate Dec. 31, 2010- Dec. 31, 2012
Proved Reserves Production Share Price
Continental Resources 58.9% 50.32% 15.8%
Kodiak Oil & Gas 187.08% 238.06% 11.75%

Source: Continental Resources and Kodiak Oil & Gas 10-K filings; author's calculations.

In the case of these kinds of investments, growth is the name of the game. So don't expect a dividend anytime soon. Both of these companies put just about every available dollar from working capital back into the business, and are normally dipping into the debt markets to cover expenses as well. One of the issues with regions like the Bakken is that the decline rates after initial production are very high, so a company needs to constantly drill more wells just to maintain existing production. This sprint style of growth can reap big rewards for investors, but if these types of companies start to miss targets, then things could get ugly.

Growth with a side of predictability
One of the big misnomers in today's E&P space is that every company should be enjoying big gains in production. The reality, though, is that the strategy to drill isn't the best strategy for every oil play out there. Fortunately for investors, there are some investments that come with a slightly lower chance of an ulcer. Both Occidental Petroleum (NYSE: OXY  ) and Denbury Resources (NYSE: DNR  ) provide more certainty than faster-growing peers but for two totally different reasons. 

In the case of Occidental, 68% of its oil comes from California, the Permian Basin in Texas, and Qatar. These assets have much slower decline rates than most shale plays, which means that Occidental can spend less to maintain production levels. This, in turn, leads to cash that is given back to shareholders through Occidental's attractive dividend yield of 2.9%.

While Denbury may not have a dividend, its unique business model provides a level of predictability that is extremely uncommon in the oil and gas space. The company focuses on enhanced oil recovery through CO2 flooding of wells that have outlived their use from traditional oil extraction methods. This translates to less capital for new acreage and less to bring a well up to production. Also, since the company's production is dictated more by CO2 supply than anything else, it is able to roughly predict its production levels for years down the road.

Source: Denbury Resources investor presentation.

Dividend hunters
Right now, Denbury's business model generates a load of free cash flow, and the company is investigating ways to return that excess cash to shareholders. On its recent conference call, management announced it was considering a conversion to a master limited partnership, which should make dividend-hungry investors salivate. In may ways, Denbury shares similar traits with other exploration and production MLPs like Breitburn Energy Partners and Linn Energy. What makes this route so attractive for investors is that these two companies have dividend yields of 10.9% and 12.5%, respectively.

Being a successful E&P MLP is a challenging route because it attempts to bring together two diametrically opposed forces. It needs to have steady cash flows to support a high-yielding distribution while operating in a capital-intensive environment with high commodity risk. To make these opposites attract, MLPs do two things: They focus on developed, mature, long-life wells that will generate cash for several years and hedge their oil and gas production to lock in prices. That hedging strategy can backfire, though, as Linn is currently under an informal investigation from the SEC regarding its hedging strategy.

What a Fool believes
The investment options in the E&P business are just as diverse as the entire energy space, and each one can serve a purpose in an investor's portfolio. The one thing that shouldn't change, though, is your approach to investing: Focus on the long term and do your homework. These tactics will help you be successful no matter what industry you choose.

In fact, some of the best picks in the energy space might not ever directly deal in the sale of energy. Our chief investment officer has dug deep into the energy space and found one behind-the-scenes energy play that has earned his choice as "The Motley Fool's Top Stock for 2013." Simply click here and we'll give you free access to our CIO's breakdown in this valuable report.


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  • Report this Comment On March 04, 2014, at 4:21 PM, David03622 wrote:

    My name is David Dudics, I am an independent petroleum geologist that is currently in partnership with a well known geologist named Jay McGovern, who has 32 years of experience working in South Texas. Jay has one of the best track records for drilling successful wells in South Texas, which keeps on getting better (45 percent success rate)! He has produced over $121 million for his investors. If you are interested in investing with us, email me at david.dudics@yahoo.com and we can get the ball rolling!

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