Want your portfolio to gush with oil profits like the old oil wells? Then these three steps should put you in the right direction. Image Source: American Petroleum Institute via commons.wikimedia.org.
The image of Wildcatters -- those fabled oilmen of the turn of the 20th century -- are that of daring risk takers who went out in search of riches below the ground. For all the success stories of these men striking it rich, there are probably dozens out there who lost their shirts. Unfortuately for investors, the oil industry today still has many of the same risks that existed back then. From oil spills to price crashes, there are tons of things out there that can kill the average oil company.
The one bright spot is that you don't need to invest in average companies; you have the ability to select the best ones from the industry, but how do you do that? Let's take a look at what you can do to help ensure that the company you're buying will be successful over the long term, and won't just be a flash in the pan.
Oil Investing: It's not for beginners
Investing in the oil and gas business can be very intimidating. First off, there is the fact that the entire business is based on a commodity, which means the industry is cyclical, and investors can get a little too trigger happy to sell at the first sign of falling oil prices when that may not be the best move.
What really makes investing in oil challenging, though, is that the industry is a complex web of sub-industries and companies that are all affected by different drivers. So not only does an investor need to know about the basic supply and demand of oil and its value chain, he or she also needs to know the drivers of that particular company and the sub-industry in which it operates.
That being said, there are a few common traits great companies in the energy space share, and being able to identify those traits will help increase your chances of picking up a great stock for your portfolio. This isn't a tried and true method to guarantee that every investment you make will be a winner. If that were the case, everyone would do it. That being said, here are three things to look for in a great company in the oil space.
1. Identify companies that have carved out that competitive niche
The term competitive advantage has a tendency to be overused. Just about every company will say it has a competitive advantage over its peers in one way or another, but most of the time, only a few of those advantages really mean anything in the market. A few examples of great competitive advantages are: A company's pipeline network that provides exclusive access to critical infrastructure such as a refinery, an integrated oil and gas company that produces and refines its own oil, so it can sell the finished products for a much higher price than a company that just sells crude, or a services company that has targeted a very small market and has a majority of that market share.
2. Look to see if those companies have shown to be successful over various commodity cycles
We sometimes don't think of oil this way, but it is a commodity just like the rest of them. This means prices can vary wildly when there is a disturbance in the supply or demand of the product. This leads to investors doing two things: They try to chase oil prices by timing their investments, or they avoid the energy industry entirely because of the volatility of oil prices.
So, one thing you should do when evaluating these companies is see whether that stated competitive advantage holds up over the up and down cycles of the business. For example, an oil and gas producer with a huge position in one of the less-explored shale formations here in the U.S. might benefit from a dominant acreage position that will lead to economies of scale and efficiency gains may still be reliant on high oil prices. So, if oil prices go through a sustained lull, that niche doesn't mean much. By contrast, an oil and gas equipment and services company that supplies parts that need constant replacement won't be as affected by the commodity price swings simply because these products perpetually remain in demand.
3. Can these companies actually generate cash from their business model?
One of the biggest challenges for any company associated with oil is that the industry constantly consumes capital, and the operations of the business need to keep up with these capital demands. Granted, certain aspects of the oil value chain will require more capital than others -- e.g., producers will spend more to bring new wells online than a refiner will that has fixed facilities -- but overall, it is a very capital-intense business.
Once you have identified whether a company has that secret sauce to keep its market share, and can handle the rough waters of fluctuating oil prices, the next step is to determine whether the company can also generate enough cash to maintain the business and hopefully have enough left over to either grow the business, or even give some of it back to shareholders through a dividend, or with share buybacks.
This is actually a pretty easy thing to check. Simply go to a company's cash flow statement and look at a few items -- on an annualized basis to account for seasonal changes, of course. The two most important ones are cash generated from operating activities and capital expenditures. What we're looking for here is a company that has a track record of generating operational cash flow in excess of capital spending. A couple tricks you should be aware of is whether a company is propping up its operational cash flow by big changes in inventory or accounts payable and receivable. Also, if a company makes acquisitions on a regular basis, you might want to consider including that as a capital expenditure.
What a Fool believes
Like I said, there is no guarantee that following these few steps will guarantee the stocks you find will be winners. In business, there are simply too many things that could go wrong that we don't see coming. Also, each sub-industry in the world of oil will have different drivers you need to consider. Identifying those drivers will make answering these questions much easier.
If you can find a company that exhibits all three of these traits, though, chances are, that company will have much greater success over the long term than a company that might see its success swing on the whims of commodity prices.
