Not many phrases will make mostly everyone jump for joy while simultaneously sending energy investors to the sad corner of the bar like the words "cheap gas." These past six months or so have been absolutely brutal for energy companies and have raised the question of whether cheap gas is here to stay. There are simply too many factors involved to conclude whether the plunge in oil will be a temporary blip or a sustained lull -- and anyone who says otherwise isn't right in the head.
That being said, the global oil market moves in many different ways. Knowing how each energy subindustry reacts to moving oil prices can help to identify whether a company is on sale and worth buying for the long term or whether it could be completely crippled. Let's look at how oil prices impact each part of the industry and how you can invest accordingly.
Lower oil prices aren't as black and white as you might think
At the first hint of weaker oil prices, too many investors in the energy space make a knee-jerk call to sell anything and everything. In doing so, they might miss wonderful opportunities in certain parts of the sector that stand to benefit from cheaper oil (or at least have a business model in which success is not tied to the price of the commodity itself). Here are some general rules of thumb the oil and gas industry will follow as prices for crude plummet.
Exploration and production companies: These companies are most susceptible to the price of oil itself since they generate all of their revenue from the sale of crude oil. Today, there are several parts of the country where the breakeven cost for a well on a per-barrel basis is higher than the current price of oil, as seen in this chart.
These are only averages, and individual company performance in these regions can vary based on a multitude of factors. Still, a good portion of E&P companies aren't making a return on new production today. Combine this with several players in the space that have little cash flow to show yet from taking on large amounts of debt to pay for these drilling programs, and you have a load of companies that are struggling to keep the lights on. Those looking for potential value investments in the industry should aim for companies that have manageable debt levels, a diversified asset portfolio, and some semblance of generating cash flow from operations to cover any future spending.
Pipelines and midstream companies: These companies are some of the least exposed to the price of oil and gas because many transport and process these products under long-term volume contracts. The larger worry for midstream companies in a low price environment is that it could curb drilling activity to the point that less oil and gas is being produced; however, it could take some time for such a situation to develop. Also, with opportunities in other parts of the business such as exporting natural gas and natural gas liquids, investors can find companies that aren't exposed to oil and gas prices at all.
Refining and chemical manufacturing: This is a tricky sector to fully grasp, because its success is based on the price of several different crude sources, as well as the price for wholesale gasoline. Different types of crudes have different prices, thanks to quality of the oil and its location, as seen in this chart.
A large part of a refiner's success will depend on whether it has the ability to process a particular type of crude. Today, for example, refiners that have access to and the ability to process large volumes of Western Canadian Select will be better off than a refiner that needs to use more Light Louisiana Sweet crude in its facilities. The companies that can exploit these discrepancies to the greatest degree possible are well positioned in times like this. Then again, they are always in a good position if they can take advantage of these inefficiencies in the market. Low oil prices will certainly help keep costs low, but it is only a small part of the investment equation when it comes to these companies.
What a Fool believes
Making investments in the energy space based solely on oil prices is a recipe for failure, because it's close to impossible to know where petroleum is headed. Honestly, at this time last year did you think oil would fall into the $50 range? Didn't think so. So rather than investing solely on the premise of where oil prices will go, it is more important for investors to understand the mechanics of each industry and focus on the qualities that pretty much all great energy companies share. If you can do this, then your chances of being a successful investor in this sector if gas prices stay low will improve significantly.