Oil and Gas Investing

$60 a Barrel Oil

Potential investors in oil and gas drilling projects are naturally interested in the future cost of oil, since it directly impacts potential investment returns.  I’m including gas well drilling projects, since there has traditionally been a close association between the prices of the two commodities.  With crude commodity prices pushing $60 a barrel, I thought this might be a good time to revisit the subject:

In early April, an analyst at Goldman Sachs, created a furor with this statement: “Goldman Sachs said that the oil market may be in the early stages of a ’super spike’, which could push prices as high as $105 a barrel.”   Then in late April Business Week On-Line reported that Tim Evans of IFR Energy Services was predicting an impending drop to the $26 to $30 a barrel range.   In the meantime, US Department of Energy’s Energy Information Agency as recently as June 7^th was forecasting an average of $53 a barrel for oil in the 2005 third quarter and providing charts showing a high 40’s - low 50’s price through 2006. 

In the company of these widely varying expert opinions, mine will not carry much weight.  Nevertheless, I believe oil will trade between $45 and $65 a barrel over the next 12 months.  Why?  Because, if oil trades above $65 a barrel for any prolonged period, we should see a significant increase in inflation, followed by a contraction in the US and world economies, thus reducing the demand for oil.  Below $45 a barrel, OPEC will likely cut back on the supply and thereby prop up prices.  After all, the US has already proven that it can keep the economy growing with oil trading in the $45 to $55 a barrel range.  So OPEC has little incentive to let the price drop below the $45 a barrel level.

While oil at current prices makes even potentially marginal drilling projects look attractive, the prudent investor will look more favorably on oil and gas investment offerings that can provide a decent return on investment even if oil once again trades down in the $25 to $30 range. 

Oil and Gas Investment Options

Recently I was asked by a casual acquaintance about the different ways an individual could invest in oil and gas.  I thought the answer might be of interest to the readers of this blog:

Purchase Exploration-Production Company Stock

The most common way to invest in oil and gas is to buy shares of stock in one or more oil/gas exploration-production companies. These companies range in size from relatively small Valero Energy Corporation (VLO) to giant Exxon Mobile Corporation (XOM).  Stock in these companies is readily available through the major stock exchanges via any licensed stock brokerage firm.  This is the best bet for an investor of somewhat limited means not only because the investor can participate with a relatively small sum of money, but because the investor can readily sell his shares quickly should the stock not perform to expectations.   

Buy Crude Oil Futures or Options

Futures and options are another way to invest in oil and gas.  Futures and options are essentially bets on substantial near term up or down changes in the price of crude. Options, cash & futures markets are separate and distinct and do not necessarily respond in the same way to similar market stimulus.  A movement in the cash market would not necessarily move in tandem with the related futures & options contract being offered. Futures and options trading involve risk of total investment loss and may not be suitable for everyone. Infinity Trading Corporation provides a good primer on the subject for those who want to take a closer look.

Buy an Interest in Production

Here the investor is either buying (a) a direct interest in a producing well or property, or (b) an interest in a partnership that owns an interest in a producing well or property.  While such investments can look like a sure bet, it’s important to realize that the tax breaks for buying production are not as generous as the ones associated with drilling projects.  Also, no one knows for sure how long the well or property will continue to produce before it depletes or is no longer economically viable to operate.  So there’s more risk than meets the eye. 

Buy an Interest in a Drilling Project

In this situation a investor either buys an interest in the partnership formed to drill a well, or buys an interest directly in a well that is to be drilled. 

The SEC views the interest, directly or through a partnership, in a production or drilling project as a security.  Such offerings should be made by NASD licensed broker/dealers.  This is because broker/dealers are required to meet very high standards of full disclosure including explaining the risks associated with the project as well as divulging the structure of the deal.   As a result, non-broker/dealer offerings will need to be scrutinized very carefully. Non broker/dealers are not under the full disclosure guidelines set out by the federal and state governments.   If you decide to look into buying an interest in a drilling or production project, I recommend that you bone up on the tax considerations as they relate to your specific tax bracket and circumstances.  You may also want to read Marvin Fergus’ article on “Evaluating Oil and Gas Projects”.