Commodity investments mainly rise and fall with supply and demand. Revolutionary changes in the energy industry provide a great example of that relationship.
Pessimists used to look on spikes in commodity investments like oil as one of the greatest threats to the world economy. Oil is a key factor in a lot of industrial activity, as a raw material or as fuel for transportation. Oil is also concentrated in a few locations around the world, particularly the Middle East, so it’s vulnerable to transport bottlenecks that result in supply shortages.
When oil prices shoot up, the economy suffers. This, though, has changed lately due to the development of oil and gas production from shale and other so-called “tight rock” formations.
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As oil prices fall, the world economy grows faster
Shale oil and gas discoveries have turned up all around the world. New technology can bring these finds to profitability in as little as eight months, compared to two years or so for many conventional finds.
The obvious direct benefit is that this new source of supply weighs on oil and gas prices—in fact it already has, moving oil prices down sharply.
This will act like a tax cut in countries that invest in shale production, and will spur economic growth. It will also attract capital to these commodity investments in many countries, but particularly in the U.S. and western Europe.
In addition to cutting prices, this diversification of oil supplies will tend to smooth out fuel prices, and commodity investments that deal in oil and fuel, by eliminating bottlenecks. When periodic oil shocks become a thing of the past, the world economy can grow even faster.
What are energy stocks?
Businesses that work in the extraction, refining and delivery of energy sources such as natural gas, oil, uranium and coal, are considered energy stocks.
Resource and commodity stocks in general should make up only a limited portion of your portfolio—say less than 20% for a conservative investor or as much as 30% for an aggressive investor. And as part of that segment, energy stocks could make up, say half of that total. The rest could hold fertilizer stocks, mining stocks and so on.
Oil and gas stocks have been below-average performers lately, and many investors are tempted to get out of the industry altogether. However, the energy industry can play a crucial role in your portfolio as a hedge against inflation. The low inflation rates of the past couple of decades deserve some of the blame for the poor performance of the industry. However, energy stocks will likely rebound in years to come as the global economy rebounds.
Shale development boosts oil production as well as natural gas
This depresses the profit margins of current oil producers, and that’s a good thing. Many of today’s top oil-producing countries have been corrupted by their oil wealth. Oil gave them all the money they needed, and provided little incentive to build the legal and physical infrastructure for other types of economic activity.
When these countries find their concentration on oil is hurting them, they may start to modernize their politics and business practices. Meanwhile, they may raise their oil production to force oil prices down. This will cut the incentive, at least temporarily, for western countries to invest in shale oil and gas commodity investments
Right now, the most controversial procedure is the hydraulic fracturing, or fracking, of hydrocarbon-bearing shale. This process involves pumping a mix of water, chemicals and other materials into shale rock formations that contain oil or natural gas. This fractures the rock and releases the oil and gas. Some environmentalists are worried that fracking chemicals will leak into drinking-water supplies.
But governments have to weigh environmental opposition against the vast increase in jobs and tax collections that shale development brings.
Interested in commodity investments like shale oil and gas?
Below are 6 tips for investing in commodity investments in the energy industry.
Look for oil and gas exploration companies that have cash flow from existing wells that is sufficient for, or at least contributes to, the development costs of additional wells.
Look at the market cap of oil and gas exploration companies versus the estimated value of the reserves they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of their findings. We like an oil and gas exploration company’s market cap to be no more than half the value of the oil and gas in the ground.
Invest in oil and gas energy stocks that own diversified drilling sites in multiple geographic locations where exploration has been successful in the past.
Junior energy stocks are risky to invest in, because it’s relatively cheap and easy to launch a penny oil or other energy stock and sell stock to the public. So the junior energy promotion business attracts more than its share of unscrupulous operators and stock promoters.
Stay away from junior energy stocks operating in insecure and politically unstable regions like Nigeria and Kurdistan, or in countries with little respect for property rights and the rule of law, like Russia or Venezuela. Resource extraction is inherently a politically vulnerable business; you can’t move the oil wells to another country, and local citizens sometimes believe that a foreign resource company is robbing them of their birthright, even though they need the foreign company’s capital and expertise to get any value out of the ground.
Have you invested in commodity investments in the energy industy? Have they been profitable for you? Share your experience with us in the comments.
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