The energy sector boasts high dividends, but it is also a difficult space to invest in. Conventional valuation tools are sometimes not very useful and the role of geopolitics is much greater than in other fields. Here is my go-to guide for investing in the oil and gas sector.
The role of geopolitics
Like anything else, the price of oil is fundamentally related to supply and demand. It should come as no surprise to anyone that geopolitics plays a massive role in determining the profitability of oil companies. Oil is the lifeblood of the global economy, and it is often extracted in countries with unstable regimes, or in places that are actively antagonistic towards Western states.
The recent seizure of a British oil tanker by the Iranian armed forces caused a temporary spike in the price of oil as the markets struggled to process the news. If the conflict were to escalate into a full-blown war, we would expect to see a more sustained period of higher prices. For instance, the Iran-Iraq war of the early 80s was a time of unprecedentedly high oil prices.
Major oil producers like Russia and OPEC (the Organisation of Petroleum Exporting Countries) also work together to constrain the supply of oil to support the global price. Although countries often cheat on their agreements by producing more than their quotas allow, in recent years this has worked reasonably well for the producers.
Valuing energy companies
The single most important contributing factor to the profitability of an oil company is oil price. This, as we have established, can be extremely variable, and largely out of the control of individual companies. For this reason, earnings do not mean as much for oil and gas firms, at least when it comes to valuation. A much better gauge of value is to look at the balance sheet and cash flow statements.
Price-to-free cash flow and price to revenue are both better representations of value than price-earnings. This isn’t to say that the market doesn’t react to poor earnings – far from it. But by using these alternative methods and exploiting the cyclicality of the oil market, it is possible to find oil companies that are relatively cheaply priced.
Another important thing to bear in mind when investing in an oil company is that they are highly capital-intensive businesses that own very large, tangible assets (oil fields, tankers, pipelines and so on). As such, they often issue large amounts of debt, which is secured by those assets. Accordingly, a high debt load doesn’t mean as much for an oil company as it would for, say, an IT firm.
Summary
Overall, investing in the oil sector is definitely very different to investing in more conventional spaces like retail or technology. There is little to no brand value in the end product, and the day-to-day operations of these businesses are typically quite opaque. But if you bear in mind what makes them unique, you can certainly find bargain opportunities.