What are the risks associated with investing in the oil and gas sector?
Investing in the oil and gas industry involves a number of significant risks. Three of these risks are the risk of volatility in commodity prices, the reduction of dividend payments for the companies that pay them and the possibility of a oil spill or other accident during the production of oil or natural gas. However, long-term investments in oil and gas companies can also be very profitable. Investors should fully understand the risks before investing in the sector.
Key points to remember
- The oil and gas sector is an attractive sector for day traders and long-term investors.
- The sector is an active and liquid market that can also serve as portfolio diversification and an inflation hedge.
- Oil and gas stocks, however, tend to be more volatile than the market as a whole, as they are sensitive to changes in the supply and demand of the underlying commodities.
- In addition, oil companies are exposed to legal and regulatory risks which may be the consequence of accidents, such as oil spills.
Understanding Oil and Gas Investments
The main risk associated with investing in oil and gas is price volatility. For example, the industry experienced significant commodity price volatility in 2014 and 2015 due to an oversupply of crude oil and natural gas. High levels of supply hurt stock prices.
In the spring of 2020, oil prices crashed against the backdrop of an economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they fell to 20-year lows.
The price of crude oil fell significantly in the first quarter of 2020. Oil fell from over $107 a barrel in July 2014 to around $20 in March 2020. Natural gas followed suit, dropping from $4.80 per million British thermal units (mmBtu) in June 2014 to around $1.60 per mmBtu in March 2020, a drop of around 70%. Natural gas is known to be seasonal and volatile in price due to greater demand during the winter. However, the drop, caused by the global lockdown and the split between OPEC and OPEC+ over production cuts, sent fossil fuel prices plunging to historic lows. In April 2020, the price per barrel of West Texas Intermediate (WTI), the benchmark for US oil, fell to minus $37.63 per barrel. This means oil producers have paid buyers to dump the raw material, fearing storage capacity will run out in May 2020.
Demand for oil during the COVID-19 crisis initially dried up as lockdowns across the world kept people indoors, but rebounded in the summer of 2021.
The entire sector has been affected by the decline in commodity prices, not just companies that engage in oil exploration and production. Oil service providers and drilling companies have been hit by lower demand for their services as production companies cannot generate as much revenue due to low prices.
Beta is a measure of a stock’s volatility relative to the broader market. Indeed, the betas oil stocks tend to be higher (ie more volatile) than the S&P 500 (which has a beta of 1.0). For example, in December 2021, ExxonMobil’s beta was around 1.37; Herringbone, 1.28; and Conoco Phillips, 1.61. The beta of the energy sector ETF, XLE, is 1.01 as of December 14, 2021.
Companies in the oil and gas sector often pay dividends. These dividends allow investments in these companies to generate regular income. Dividends are therefore attractive to many investors. However, there is a significant risk that the dividend will be reduced if the company is unable to generate enough revenue to fund payments to investors. This risk is closely linked to that of low commodity prices. If companies earn less revenue from the sale of their products, they are less likely to fund regular dividend payments and the likelihood of a cut is greater.
For example, Seadrill, an operator of drilling rigs, cut its substantial dividend payout in November 2014 and the stock price fell more than 50%. The cut took many investors by surprise and highlights the risk associated with a dividend cut. Investors in the company lost a regular dividend payment, and they also lost much of their stock value.
Risk of oil spill
Another risk in the oil and gas sector is that an accident could occur, such as an oil spill. This type of accident can be devastating and cause a company’s stock price to plummet.
BP saw its stock plummet following the Deepwater Horizon oil spill in 2010. The stock was trading around $60 before the spill and fell to $26.75, down more than 55%. The Deepwater Horizon oil rig exploded and sank, leaving an oil well at the bottom of the sea that released more than 4.9 million gallons of oil into the Gulf of Mexico. The oil spill had a serious negative impact on marine life and habitats in the gulf. BP is still grappling with lawsuits and other issues related to the incident years later.
In contrast, Exxon shares didn’t fall much after the Valdez incident in 1989. The Valdez tanker ran aground in Alaska’s Prince William Sound, spilling more than 11 million barrels of oil into the water. Exxon’s stock fell 3.9% in the two weeks after the spill, and it recouped those losses after a month. The Valdez spill physically released less oil into the water. Yet the impact of the Deepwater Horizon spill on BP’s share price shows how such an incident causes a significant decline due to the availability of information in the connected age, as well as the impact of the 24-hour news cycle. The possibility of future spills or other incidents may pose a greater risk than in the past.
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