Basics of Oil and Gas Investing

According to CFRA, one of the world's largest independent investment research firms, currently, it's an excellent M&A environment for buyers as industry consolidations continue to offer new and varied investment opportunities. 

On DealStream, you’ll find plenty of potential profit partners and opportunities to buy commodities like oil.

Becoming an oil and gas investor can offer significant opportunities for financial gain. But, like any investment, there's also a fair amount of risk.

There are several ways to break into the energy game. You can purchase mineral rights, buy oil futures, invest in direct participation plans, or purchase energy stocks, mutual funds, or exchange-traded funds (ETFs). 

First, it’s important to acquaint yourself with the various types of oil and gas companies, so you know what space you’ll be playing in. The oil and gas industry consists of three main segments that are aptly referred to as upstream, midstream, and downstream companies.  

Upstream companies (sometimes called Exploration and Production companies) focus on costly and occasionally high-risk activities, such as exploration (including procuring surveys and land rights) and extraction (including drilling and removal).

Midstream companies often partner with Upstream companies and focus on various activities related to moving oil from the ground to a refinery. These activities include pipeline construction, shipping, and storing raw materials. 

The Downstream side of the business encompasses companies involved in refining crude oil and gas into heating oil and gasoline, for example, and delivering them to consumers.

There is also some vertical organization in this industry, as some companies take an even broader "wellhead to consumer" approach.  These "Integrated oil and gas companies” explore, produce, refine, and distribute oil and gas products as opposed to upstream or downstream companies specializing in only one area. 

And finally, there are entities known as “Oilfield Service companies” which provide equipment, construction, and various support services. 

With the basics under your belt, here are some ways you can invest in oil and gas:

Mineral Rights

Mineral Rights cover not only solid minerals but also oil and natural gas. Having Mineral Rights means you are entitled to explore and make the most of these underground resources. You can purchase Mineral Rights from upstream oil and gas companies, brokers, or directly from mineral rights owners. 

Oil Futures

You could buy crude outright in the spot market, and for most investors, the way to do that is by purchasing crude oil futures or options on oil futures. 

Oil is the world's most heavily traded commodity, and like other commodities, crude oil trades on the New York Mercantile Exchange.

Oil futures are derivative securities that give shareholders the right to buy crude oil by the barrel at a determined price by a settlement date. These are indirect investment options that shareholders can order through a broker. 

Because crude oil prices may increase or decrease before the purchase date of the contract, this is a purely speculative trade. You can either short-sell the future and bet against the future cost of crude oil or bet on it to rise and sell it for more. 

Oil and Gas Wells with DPP

You can also invest in oil by owning various oil companies. One way to do that is through a Direct Participation Plan (DPP). With a DPP, you're buying a percentage of the assets and interest of an operating oil company. You gain all the advantages of owning a portion of the business without becoming mired in the details of setting up or getting involved with the operations. Because DPPs are not traded on the open stock market, investors must meet minimum asset and income thresholds upfront. The benefits investors can expect from DPPs that are either Limited Partner or Working Interest ownerships include high ROI potential, portfolio diversification, tax incentives, and the generation of long-term passive income.

Among the more common DPPs are Income Wells and Developmental Drilling Programs, which involve investing in either existing wells or drilling for new oil in proven areas. Both can provide an immediate tax write-off against annual earned income.   There are also high-risk Exploratory Drilling Programs involving wildcat wells (wells drilled outside of known fields or in entirely new areas) and Rework Programs - the least common of all DPPs focused on reviving low-producing wells.

Potential Risks

While there are many positives to DPPs, no investment is risk-free. By considering the potential risks of oil and gas investments, you can make smart decisions that will aid in the successful growth of your assets. 

 Oil and gas commodities are volatile by nature. A volatile oil price can destabilize production costs and affect output. This excerpt from the January 2023 issue of Oil & Gas Journal describes the current state of the energy market: 

“The outlook for global economic growth has deteriorated amid high inflation, falling confidence, and tighter monetary policy. Oil prices already weakened as we approached the end of 2022. Macroeconomic headwinds lead to concerns about oil demand. However, the oil market is expected to tighten in 2023 following the EU ban on Russian crude and products and OPEC+ production cuts, as the US is not there to fill the gap.

Similarly, the IEA Oil Market Report has this to say,

"While lower oil prices come as a welcome relief to consumers faced [by] surging inflation, the full impact of embargoes on Russian crude and product supplies remains to be seen. As we move through the winter months and towards a tighter oil balance in 2Q23, another price rally cannot be ruled out."

Both sources illustrate the delicate balance of supply and demand and reveal the unpredictability of a commodity that is such a big player on the world stage. Investors must also recognize the potential large-scale accidents, another risk unique to the oil and gas industry. 

Large oil spills can be significant, dangerous disasters. Oil spills can result from many factors, such as mechanical failures and accidents involving refineries, tankers, pipelines, storage facilities, and drilling rigs. One of the most notable in recent history occurred in 2020 when Deepwater Horizon, an oil drilling rig operating in the Macondo Prospect in the Gulf of Mexico, exploded and sank, resulting in the death of 11 workers. 

Of course, as with any investment, before making a decision, you should perform due diligence and evaluate the liquidity of a company's stock, any recent or planned dividend cuts, and the risk of estimating the reserves tied to a company's operating costs. 

Many Investment Choices: Stocks, Mutual Funds, ETFs

Stocks

Some of these oil and gas companies may be public, so you might consider purchasing stock in an oil business such as Exxon Mobil Corp. (XOM) or Chevron Corp. (CVX). Similarly, you could invest in Mutual Funds and Exchange Traded Funds (ETFs). Both are among the fastest and simplest ways to start investing. 

Mutual Funds

Investing in mutual funds, in general, mitigates the risk associated with picking individual stocks without an array of commission charges that are primarily associated with stock purchases. Natural gas funds, for example, might represent a portfolio of stocks of natural gas companies and focus on particular areas of the industry, such as natural gas drilling companies. The Vanguard Energy Fund Investor Shares (VGENX) and Fidelity Select Energy (FSENX) are among the largest mutual funds focused on energy.

ETFs

ETFs, or "exchange-traded funds," are bought and sold like common stock on a stock exchange.  When you invest in an ETF, you hold a basket of stocks or other securities, increasing diversification. For that reason, ETFs are considered a lower-risk investment. 

Proceed with caution

Finally, doing your research cannot be understated. The US Securities and Exchange Commission (SEC) cautions individual investors to be aware of certain risks and possible fraudulent activity involving private securities offerings for oil and gas ventures. The SEC's Office of Investor Education and Advocacy issued an alert "to educate individual investors about certain risks and possible fraudulent activity involving private offerings of securities for oil and gas ventures." Their document warned investors and consumers that "The number of fraud cases related to private securities offerings for oil and gas ventures has increased over the last few years." Beginning in 2006, "the number of SEC cases has averaged more than 20 per year." The agency reminds investors that in addition to standard investment risks, investing in private offerings "carries unique risks, and private oil and gas offerings have additional risks to consider."