With the upcoming mass adoption of electric vehicles and possibly hydrogen1, the title looks outdated. Yet, in this low price of the commodity, Oil stock often offers a reasonable bargain. This is not a stock that you will hold forever, but buying something at a bargain is always a smart play. Here, we present you with a basic lesson on how to invest in an oil and gas stock.
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At this moment, we will specifically talk about the upstream oil companies, that is, the company that operates in the exploration and production of oil. To name a few: Chevron, Exxon, Aramco, Shell, British Petroleum2
In This Issue
- Survivability Check: Future Energy
- Race for the reserve
- Race to Zero
- Balance Sheet in Imbalance Market
- Investor Key Takeaway
The Days The Oil Stand Still: Future of Oil and Gas Stock
We know that value investors are always enthusiasts to check annual reports or any other financial documents to make an analysis, we are glad you do that. But, the first thing to do is to check whether this industry could survive or not. Even when we aren’t planning to hold this forever, it doesn’t mean that we blindly invest in an industry without tomorrow’s prospects.
It will be a long debate if we try to answer whether the EV will wipe out oil companies on this planet (spoiler alert: it won’t). We put it simply, every kilogram of gasoline could generate 46 MJ energy, it is far superior to an EV battery with 0.3 MJ per kg energy density. Therefore, the oil company will stay here – no matter how green energy enthusiasts and EV investors hate it.
We leave the detail here.
After you know that your watchlist is safe, we are ready for the next step.
Race for The Reserve: Scarcity That Threat Oil and Gas Stock
Dealing with the oil industry is dealing with nonrenewable resources. It is not Apple that can manufacture iPhone at any time and at any volume. Oil is depleted. An oil company has to explore new locations every year to maintain its reserve. Our preference is to invest in a commodity company that has enough reserve – abundant if possible.
A low reserve oil company means future cost since it needs to obtain a new location via exploration. The worst is, the company lost all its reserves. It feels like investing in a ticking bomb.
Now we’re getting deeper into the financial report. an oil company usually includes its reserve on the first pages of its annual report. Here is Chevron’s annual report as an example.
Given Chevron’s production rate at 3.08 M barrel oil equivalent per day, its reserves could last for 9.87 years (calculation = 11.1 B barrel oil equivalent divided by 3.08 M per day). Our preference is a company that has around at least 7 years reserve, otherwise, we need to think twice.
Race to Zero
The most problem for oil companies is their product is commoditized. This means that companies have no power to control its price. The price of a barrel of oil is the same everywhere and dictated by the market will, and the will of the market is volatile. Take a snapshot of the wild of oil price, we have US$147 per barrel of oil in July 2008, before wildly sliding to US$34 level in Christmas 2008.
This makes complexity for the oil company. This is why we don’t like to invest in the Petroleum business. Even, we attribute a poor competitive advantage to ExxonMobil due to this reason.
Now, when the price of the product is determined by the market, things that the company could do is strip the cost, especially production cost. And as you have expected, the cost of production of the oil depends heavily on the geological location of the reserve.
We like to invest in an oil company that has a premium location like Saudi Aramco. Its reserve located near the desert surface – makes the Saudi need only a little effort to lift the oil and distribute it. Meanwhile, oil reserves deep buried in the snowy Arctic need a lot of money to be extracted. This condition is worsened by the fact that the company needs to warm the pipe and infrastructure to distribute the petrol.
At the end of the day, a company with low lifting costs like Aramco has more advantage in the low commodity price environment.
Strong Balance Sheet of Oil and Gas Stock as Shock Absorber
When investing in the oil industry we meet more problems than the solution. We have a high level of capital spending (exploration, infrastructure, salary) and an uncertain market (none knows the price in the future). Facing this circumstance, the company needs a solid rock balance sheet. Even in nonprofit condition, with $20 USD oil per barrel, for instance, the company have to survive. This capability is reflected in the balance sheet.
Our criteria are a company that holds a reasonable amount of cash that can cover its short-term obligation. An operating cash flow that can cover its future expense. In short, we prefer a company that has the highest survival rate.
Take a look at Chevron Balance Sheet here
As we can see, Chevron’s cash position is at 5.5 B – dwarf its short-term obligation with 1.54 B. In the near term, Chevron has no problem. Looking further at its Cash Flow Statement, we find out that Chevron’s Operating Cash FLow is at its worst in the last 3 years (10.5 B). Thanks to the pandemic seal for mobility. Even with its worst condition, Chevron has the capability to cover its long-term debt (42.7 B) in approximately 4.5 years.
Investor Key Takeaway
- Investors need to very careful when dealing with Oil and Gas Stock. This is a capital-intensive industry that drains the capital with no control of its price. A careful look at its balance sheet, cash flow along operating costs will serve as the first defense line of risk-taking.
- On the contrary, the wild business environment will provide a very high barrier to entry. means that the competition will take place within the player of the industry.
- This post covers only upstream business, the discussion about the downstream industry will be presented at another chance.
As the final word, we iterate the message. This isn’t stock that you hold forever.
- according to Tesla shareholders
- some of them has a downstream business also, but they well known as oil producer