Many investors have either lost money or realized relatively low returns from oil and gas investing during the past 15 years or so. However, growing awareness of the renewed strength within the energy sector surely will draw new investors back into oil and gas. Those investors becoming interested in the energy sector should pay close attention to seven basic rules that will improve their returns in this asset class and help them avoid past mistakes.
Rule 1
Don't focus on oil and gas prices.
Accurately predicting oil and gas prices has proven to be an impossible task, even for the experts. Furthermore, by the time a consensus on future prices exists, the market already has revalued most real and financial oil and gas assets, thus eliminating the perceived upside. The rule is readily apparent when, despite sudden run-ups in oil and gas prices, investors complain stocks are "fully valued" and production buyers complain assets are overpriced. It is simply too difficult to time the market effectively.
But the rule has a more dramatic implication that few investors ever realize. The focus on oil and gas prices is a dangerous distraction. It is precisely because too many investors focus on prices that they fail to focus on the only real way to make money in the oil and gas business. (See Rule #2).
Rule 2
Focus on technology.
There is an old saying that the oil business has always been a great business as long as you are finding enough oil at a low enough cost. The key to finding enough oil at a low enough cost is to repeatedly employ the best available technology and knowledge.
In fact, today the pace of technological developments in the oil patch has created a significant increase in new and profitable opportunities that did not exist 10 years ago. Oil and gas companies have cut their reserve finding costs in half since 1986 and consequently began generating strong cash flows even before Saddam Hussein's most recent mischief.
Rule 3
Don't just buy stocks, buy assets.
Oil and gas stocks often trade at twice the price of their underlying assets in the private marketplace. Therefore, the patient investor may realize greater long-term rewards through the private accumulation of cash-flowing oil and gas assets. Furthermore, direct energy investments provide true negative correlation with traditional stock and bond asset classes, and thus provide better diversification.
Studies have shown that direct energy investments have significantly outperformed energy stocks during periods of higher inflation. Through proper management, an investor may employ Rule #3 to establish a portfolio of direct energy investment that will have relatively good asset liquidity, too.
Rule 4
Don't just buy oil and gas reserves, drill for them.
Investors correctly perceive the purchase of oil and gas reserves as a lower risk investment than drilling for them. However, projected cash flows and rates of return from reserve acquisitions rely heavily on the level of oil and gas prices in the first couple years. Drilling for reserves often allows the investor to average more of his capital investments over time, thus reducing price and market timing risks. Moreover, investors seeking higher investment returns in addition to negative correlation will find a properly managed drilling effort much more likely to meet their objectives. Recently, many companies have achieved finding costs through drilling at half the per-barrel cost realized through lower-risk acquisitions. The resulting high gross margins from these drilled reserves deliver higher rates of return and less price risk to the investor than production acquisitions do.
Rule 5
Beware of the company with the good track record.
Investors correctly look to an oil company's finding cost track record as a key basis for judging a direct energy investment opportunity. But investments with companies boasting a good track record often have several problems.
Those companies are often financially stronger, and thus less motivated to agree on reasonable investment terms; are finished drilling their better-quality properties and now are seeking an investor to take higher risk drilling lower-quality properties; or are not recognizing the fact that their track record isn't quiet as good as it appears to be.
The track record trap is doubly troublesome for committee-centered investors who look to consultants and the appearance of good past performance to diffuse accountability for the investment decision.
Rule 6
Never invest because a familiar name is already in the deal.
There is no substitute for thorough analysis of an oil and gas investment (or any investment).
Rule 7
Get some help.
While oil and gas investments may be attractive for a variety of reasons, it pays to hire an expert who will take the time to learn an investor's objectives and then help achieve them. There is no point allocating capital to the energy sector if the investment strategy is inconsistent with the initial objectives, or if the investment analyses fail to support the strategy.
An investor following these basic rules should be able to make money investing in oil and gas over a multiyear period.
In hindsight, there might be good times to increase or decrease allocations to this asset class. For now, however, today is as good a day as any.
