Should You Invest in Oil and Gas Companies? Consider These 3 Risks

Fact checked by Ariel CourageReviewed by Thomas J. CatalanoFact checked by Ariel CourageReviewed by Thomas J. Catalano

Investing in the oil and gas industry carries a number of significant risks. Three of those risks are commodity price volatility risk, cutting of dividend payments for those companies that pay them, and the possibility of an oil spill or another accident during the production of oil or natural gas. However, long-term investments in oil and gas companies can also be highly profitable. Investors should fully grasp the risks before making investments in the sector.

Key Takeaways

• The oil and gas sector is an attractive sector for both day traders and long-term investors.
• The sector is an active and liquid market that can also serve as a portfolio diversifier and inflation hedge.
• Oil and gas stocks, however, tend to be more volatile than the broader market as they are sensitive to changes in the supply and demand of the underlying commodities.
• In addition, oil companies are exposed to legal and regulatory risks that can be the consequence of accidents, such as oil spills.

Price Volatility

The main risk associated with oil and gas investments is price volatility. The supply and demand of oil as well as geopolitical events cause oil and gas prices to fluctuate, impacting the stocks of these companies.

For example, during the COVID pandemic, the price of crude oil dropped substantially in the first quarter of 2020. Oil went from over $138 a barrel in June 2014 to a low of $23 in April 2020. Natural gas followed suit, going from $5.79 per one million British Thermal Units (mmBtu) in June 2014 to around $2.00 per mmBtu as of April 2020, a drop of around 65%.

Natural gas is notorious for being seasonal and volatile in its price due to greater demand during the winter. However, the drop, caused by the global lockdown and the split between OPEC and OPEC+ over production cuts, plunged prices for fossil fuels to historically low levels.

Important

In the spring of 2020, oil prices collapsed amid the economic slowdown due to COVID. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows.

In April 2020, the price of a barrel of West Texas Intermediate (WTI), the benchmark for U.S. oil, fell as low as minus $37.63 a barrel. This means oil producers paid buyers to take the commodity off their hands over fears that storage capacity could run out in May 2020.

Beta is a measure of a stock’s volatility relative to the overall market. Indeed, the betas of oil stocks tend to be higher (i.e., more volatile) than the S&P 500 (which has a beta of 1.0).

For instance, as of August 2024, Chevron’s beta was about 1.09 and ConocoPhillips had a beta of 1.25. Only Exxon Mobil’s was below 1 at 0.89. The beta of the energy sector ETF, XLE, was 0.41 as of August 2024.

Dividend Cuts

Companies in the oil and gas sector often pay dividends. These dividends allow investments in those companies to make regular income. The dividends are, therefore, attractive to many investors.

However, there is a significant risk that the dividend can be cut if the company is unable to earn enough revenue to fund the payments to investors.

This risk is intertwined with that of low commodity prices. If companies earn less revenue from the sales of their products, they are less likely to fund regular dividend payments, and there is a greater likelihood of a cut.

For example, again during the COVID-19 pandemic, Shell cut its dividends for the first time since World War II to preserve cash for the drop in demand for oil.

Note

The largest oil company by market cap is Saudi Aramco, with a market cap of $1.8 trillion as of August 2024. Saudi Aramco is followed by Exxon Mobil, with a market cap of $527 billion.

Oil Spill Risk

Another risk in the oil and gas sector is that an accident could occur, such as an oil spill. This type of accident can be devastating and cause a company’s share price to go into free fall.

BP saw its stock fall in the wake of the Deepwater Horizon oil spill in 2010. The stock was trading around $60 prior to the spill and dropped to as low as $28.88, a decline of about 50%.

The Deepwater Horizon oil rig exploded and sank, leaving a sea-floor oil gusher that released over 4.9 million gallons of oil into the Gulf of Mexico. The oil spill had a severe negative impact on marine life and habitats in the Gulf. BP was still dealing with lawsuits and other issues from the incident years later.

In contrast, Exxon’s stock did not fall that much after the Valdez incident in 1989. The Valdez tanker ran aground in Prince William Sound in Alaska, spilling over 11 million barrels of oil into the water.

Exxon’s stock went down 7.2% in the two weeks after the spill, and it recovered those losses after a month.

The Valdez spill physically released less oil into the water. Still, the impact of the Deepwater Horizon spill on BP’s stock price shows how such an incident caused a major decline due to the availability of information in the connected age, along with the impact of the 24-hour news cycle. The possibility of any future spills or other incidents may be a larger risk than it has been in the past.

How Can I Invest in Oil and Gas Companies?

It is very straightforward to invest in oil and gas companies. You can outright buy the stocks of these companies, such as Exxon or Chevron. You can also invest in exchange-traded funds (ETFs) that track different parts of the industry. Keep in mind that oil and gas prices can be volatile, with large price swings, as the price is closely related to geopolitical events.

Can You Invest Directly in Oil?

You can invest directly in oil by purchasing oil futures. Note that you will need to trade these on a commodity exchange and if you hold the future to delivery, you will need to be prepared to take delivery of physical oil. This is complicated for the average investor and there are better ways to gain exposure to oil investments.

What Are Some Oil ETFs to Invest In?

There are plenty of oil ETFs to choose from, including the United States Oil Fund (USO), the United States Brent Oil Fund (BNO), the ProShares K-1 Free Crude Oil Strategy ETF (OILK), and the United States 12 Month Oil Fund (USL).

The Bottom Line

There are many risks when investing in the oil and gas industry, including dividend cuts, accidental oil spills, and the price volatility of oil and gas. That being said, it is a popular industry to invest in due to the potential of high returns, its liquidity, and as a means to diversify one’s portfolio.

Before investing, individuals should thoroughly understand the industry and the companies they are looking to make bets on, as the industry is vast and there are many legal and regulatory risks to encounter.

Read the original article on Investopedia.