Diversification Within An Oil & Gas Portfolio
One of the challenges involved in investing in multiple companies from the oil and gas sector is ensuring that you still achieve a degree of diversification.
This isn’t always easy, but it can usually be done with a little thought, as I’ll explain in this article.
Identify the differences
The first thing to remember is that diversification doesn’t just happen, it needs to be planned before you buy any shares!
Whatever sector you are interested in, you need to identify a set of criteria you can use to achieve meaningful diversification, so that the share prices and fortunes of the companies you invest in are not too closely correlated.
Here are the factors I use to help me manage my oil and gas portfolio:
Different regions of the world have different risks, opportunities and potential end markets. Disruption doesn’t just mean operational failure — the [lack of] rule of law, political interference and civil unrest or military conflict can all play their part.
Fluctuating tax regimes and export market access terms are also location-specific. In Russia, for example (a country famed for the risk of political interference), oil duty is charged on exported oil and calculated to ensure that the producer makes the same profit they would have done if they had sold the oil into the domestic market — as this quote from an Exillon Energy (LON:EXI) market update explains (my emphasis):
During the period, we exported 1,222,049 barrels of oil at an average realised price of approximately US$ 105.8 per barrel, and sold 2,048,551 barrels within Russia at an average realised price of US$ 42.6 per barrel. The difference in the sales price of exports and domestic sales is principally a function of export duty. We are free to sell either for export or domestically, and our netbacks for domestic and export sales are similar.
When it comes to diversity, size matters. In my oil and gas portfolio I have companies of all sizes. My goal is to achieve a reduction in volatility and a variety of investment timescales.
Starting at the top, I own shares in BP (LON:BP). My intention is to hold these indefinitely, benefiting from the dividend income and perhaps topping up my holding occasionally, if a good opportunity arises.
In the middle, I have shares in several mid-cap exploration and production (E&P) companies with solid production levels and decent profitability — such as Afren (LON:AFR) and Salamander Energy (LON:SMDR). Note the geographic diversity between these two companies. Although this type of company rarely pays a dividend, their established production revenues means that they are viable ongoing businesses with medium term growth prospects — but they are also candidates for a takeover bid at some time in the next few years.
Finally, at the bottom of the pile, size wise, I hold shares in a few small cap E&P companies such as Trap Oil Group (LON:TRAP) and Antrim Energy (LON:AEY). These are more volatile and run the risk of total failure, but they also provide the potential for big gains over quite short periods.
I don’t normally buy shares in pure exploration companies, as you are, quite literally, investing in hopes and promises, and the risk of a total loss is too high for my liking.
3. Gas markets remain very localised
Most oil producers aim to sell their product on the international market, where prices are usually highest. In most cases, this means that their profits are directly linked to Brent Crude — so if Brent falls heavily, so will their profits.
To some extent, it’s not possible to avoid this sector-wide risk — but once you add gas into the equation, it becomes much easier to handle.
Although LNG is becoming an increasingly important force in the energy markets, gas markets globally are still quite localised. Pipelines are practical on a local and regional level, but there are limits and unlike oil, which is a truly global commodity, gas is sold at vastly different prices in different parts of the world.
The biggest example of this in recent years is the collapse in natural gas prices in the US, caused by the glut of gas from shale drilling. Even though gas prices fell until many gas producers were losing money, gas prices elsewhere in the world — mainly Europe and Asia — continued to rise.
The US does not currently have the network of pipelines and LNG export facilities necessary to export its surplus gas, so it cannot undercut more expensive suppliers who can export LNG or who are located near to their customers and can supply them via pipelines.
Keep it simple
I hope this has provided you with some ideas as to how you can create a diversified oil and gas portfolio that is effective in reducing risk and maximising potential returns.
It’s not an exact science and certainly doesn’t guarantee positive returns, but I believe it does reduce some of the downside risk I might face from a less carefully constructed and balanced portfolio.
Although I could make a case for putting all my eggs in one carefully researched basket, such as Kurdistan or East Africa, I don’t take this approach because there are too many external factors that can derail companies’ plans through no fault of their own.
Disclosure: Roland owns shares in BP, Trap Oil Group, Salamander Energy, Afren and Antrim Energy. He does not own shares in any other companies mentioned in this article.