Continuing with our discussion on alternative investments, our discussion this week focuses on oil & gas.
Whenever the topic of oil & gas investing comes up, most people envision pumpjacks bobbing up and down in a West Texas oil field like a chicken pecking the soil for worms. Although a vital cog of the oil and gas industry in the United States, oil production is only one facet of private oil and gas investing.
Investment in the oil & gas market vertical can be made along any or all of several stages including:
Investments can be in the form of both direct and indirect participation.
Indirect passive investments can be in the form of private equity, private debt, and buying oil & gas royalties.
There are many ways and many levels for investing in oil & gas but no matter how you participate, the oil & gas industry bears characteristics common to other alternative investments and characteristics that are unique.
Let’s evaluate oil & gas according to the following criteria:
- Non-Correlation to Broader Markets.
- Lack of Volatility.
- Cash Flow.
- Above-Market Risk-Adjusted Returns.
- Security (i.e., backed by hard asset).
Non-Correlation to Broader Markets –
Research conducted by the Federal Reserve Bank of Cleveland looked at movements in the price of oil and stock market prices at the daily, weekly, and monthly levels and found little correlation between oil prices and the stock market.
A common belief is that oil prices are negatively correlated to the stock market, so when oil is up, stocks must go down, and vice versa. The results of the research conducted by the Federal Reserve Bank of Cleveland say otherwise; concluding that oil prices do not predict stock prices and vice versa in any significant way.
In the end, oil & gas prices are non-correlated to the broader markets. In other words, you shouldn’t expect oil & gas prices to move with the rise and fall of the stock market.
Lack of Volatility –
Oil & gas prices can experience periods of extreme volatility. An article in oilprice.com appearing in February of this year declared the price of oil to be more volatile than one of the most volatile investments around Bitcoin.
The article revealed that as of February 10th, West Texas Intermediate (WTI) oil’s one-month realized, or historical, price volatility stood at 105.3%. Compared to Bitcoin’s historical price volatility of 42.3% calculated at the time, the price of oil was more than twice as volatile as Bitcoin’s.
Oil’s price volatility in 2020 can almost be entirely attributed to the economic fallout from COVID-19 and social distancing and lockdowns conducted on national and global levels.
The problem with oil price volatility is that there’s always a COVID-19 around the corner that will affect oil price fluctuations since oil, more than any other global commodity is subject to geopolitical factors around the globe. Other factors affecting price volatility include currency valuations, trade policies, governments, and tax reforms.
Cash Flow –
Oil & gas investments are coveted for their cash flow. However, unlike other alternative assets with fixed returns, cash flow from oil & gas fluctuates with market prices.
Assets that appreciate have intrinsic value – value separate from increasing prices due to inflation. Oil & gas have an intrinsic value from income generated from production and sales.
Oil & gas investments can benefit from both an increase in value from operations as oil production and prices increase, but can also benefit from increases in the price of any underlying real estate or exploration or drilling rights.
Above-Market Risk-Adjusted Returns –
Historically, average annual returns from oil & gas investments have exceeded those of the S&P 500. When factoring in tax benefits, the gap becomes even wider.
Although there is no standard index for gauging returns from oil & gas investments, analysts often look to returns from public oil & gas funds for comparison.
For example, in the last 15 years, the Energy Select SPDR ETF (NYSEARCA:XLE) that invests in oil and gas companies, gave 200 percent more return than Dow Jones Industrial.
Despite green initiatives, the demand for oil and gas is expected to go up soon, which in turn will lead to an increase in the prices as supply is constantly diminishing thereby increasing the potential return on investment for investors.
Oil & gas investments are good in terms of security since you have a tangible asset in equipment and underlying real estate or rights you could always sell as a last resort.
Although oil & gas has many of the qualities savvy investors find appealing with alternative investments, the one weakness of oil & gas investments is price volatility – subject to extreme periods of boom and bust.
Overall, an oil & gas investment is a superior option to many other alternative asset classes for potentially building wealth, but it’s not without its flaws.