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So you want to invest in oil and gas, there’s a stock for every risk appetite but which will suit you best?

There are several ways to play the oil and gas sector, but, they all carry different levels of risk

oil and gas operations
Here's the who's who of the sector.

Crude oil and natural gas are fundamental and ubiquitous commodities throughout the capitalist system, so, putting any environmental proclivities aside, it should be obvious that the petroleum sector is a core part of all investment portfolios.

But, who are the sector’s main players, and which stocks should you be investing in?

First and foremost, you could also have a go at trading the commodities themselves.

That’s not so easy, however, not unless you have substantial facilities and you’re comfortable getting your hands dirty, literally as well as figuratively.

It is unlikely that very many private investors will have the gumption for physical crude trading.

Most suit and tie oil traders will be prepared to deal in oil futures and an array of other derivative contracts. This is an often volatile market and it is essentially a 24/7 market. So, this arena is not for those with faint hearts or shallow pockets.

Many ways to navigate oil and gas equities

Equity investing can offer a more accessible and diverse way to play the petroleum market.

In London, particularly, there are many quite different opportunities to invest. 

From taking long-term portfolio holdings of BP or Shell shares, to leveraged CFD trading positions ‘seat of the pants’ exploration stocks on AIM, and, everything else in between, there are avenues for most tastes and risk appetites.

Investing in ‘Big Oil’ integrated majors

London is home to a pair of the sector’s more prestigious oil majors, BP PLC (LON:BP) and Royal Dutch Shell PLC (LON:RDSB).  Both are stalwarts of any blue-chip portfolio.

These are the sector juggernauts. Investing here is all about income and that’s why both have fought tooth and nail to maintain dividends in recent years against the backdrop of sharply lower oil prices.

Scrip-payments, asset sales and cost cutbacks were all deployed to save shareholder’s yield.

Whilst the sector has experienced a sharp downturn in investment following the crude downturn in 2014, the tide now appears to be turning as the oil price is rallying.

After the period of rebalancing, the improving oil price is having a big impact on cash flow generation. Indeed, some analysts see the price of oil returning to US$100 per barrel over the next two years - and, that is expected to see dividend cover improve to around 200%.

It bodes well for the Big Oil stocks and their ‘slow-and-steady’ income investors.

Exploration and wildcat wells

We’re now talking about the complete opposite of BP or Shell. London is arguably the premier market for pre-revenue oil and gas stocks.

This is where you’ll find petroleum executives with bright ideas and a need for capital.

London’s investment community is rather robust and knowledgeable when it comes to oil and gas prospecting - and that’s one of the reasons the world’s explorers list here.

The shareholder registers of the market’s preferred players most likely comprising a good mix of prestige institutional investors, deep-pocketed hedge funds, private equity, and frequently, a depth of highly engaged private investors.

The latter group, are often the most susceptible to the ambitious and seemingly compelling forward-looking statements that flow out of small-cap boardrooms.

Here, companies are an awful lot smaller - in terms of capital, headcount and operational capacity.

Ambition and salesmanship are, however, definitely not in short supply.

Put most simply, this is the business of finding new hydrocarbon resources, and, its most often done by small companies that are set-up to risk their very existence in the pursuit of new discoveries.

In rudimentary terms, the idea is to make an educated guess where the oil or gas may exist and then drill a hole to prove it.

Naturally, that’s much easier said than done. Successful explorers reward their investors handsomely. This is a binary business. And, it is not particularly uncommon for a small cap oil speculator to double or even triple their initial capital investments.

At the same time, a well failure can decimate a trading position and, moreover, a bad enough well result can take down a company in its entirety.

Although there’s a great deal of hard science and engineering involved for the companies, the outcomes for outside speculators are analogous to those seen in roulette.

At any given time, the average small-cap explorer may have just enough capital to deliver the programme they’re working on at that moment.  They don’t yet generate their own cash and future fund-raising is almost always a strong probability.

In case you were in any doubt before, it is fair to now conclude that small-cap exploration isn’t the investment arena for the widows and orphans fund.

E&P independents

E&P ought to stand for expertise and pragmatism (but, it actually means Exploration and Production).

Companies like Tullow Oil PLC (LON:TLW) and Premier Oil PLC (LON:PMO) are good examples of the companies found in the middle-ground between the multinational, vertically integrated majors and the AIM-market exploration minnows.

Here, there are many well established and well-supported oil and gas companies.

They have production, some have quite substantial volumes of it too, but, unlike the Shells and BPs of the world, they are still not income investment plays.

These businesses are far from ex-growth. Typically, they are independent, i.e. they are not integrated (in other words they sell crude oil, unlike the majors they have no involvement in any of the ‘downstream’ activities). Most have a spread of assets including producing fields, field development projects, proven but undeveloped discoveries and greenfield exploration ventures.

Such companies are valued-based on the cash flow they generate and the (risk discounted) barrels that are proven in the ground. Whilst exploration potential very much remains a relevant and attractive factor for investors, it is not what underpins the share price.

Exploration risk is often shared through multi-partnered ventures, and, the negative impact of bad results dissipates more easily because the portfolios already hold material proven assets.

Equity-based funding is rare in this segment, largely because upwards pointing production growth allows for debt funding.

So far so good, right? The downside risk comes from the fact that the more aggressive players became highly leveraged earlier in the decade when the price of crude peaked well above US$100 per barrel.

Most of those firms have since rearranged their financing, nonetheless, there has been something of a lag on growth because cash is being prioritised towards debt repayment - albeit, the crude rally to US$80 in the first half of 2018 eases the pressure.

With leverage now less of a concern, the mid-sized independents may offer investors the best of both worlds.

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