Oil prices rise as stimulus hopes ease growth concerns

Oil and gas companies may draw quite a bit of scrutiny from environmentalists, but investors view the industry through very different standards. In fact, companies involved in oil and gas drilling, refining and transmission services are quite popular. Here are five reasons why private equity investors like these firms so much.

Always in Demand

The world has complex and vast energy needs. In the United States, over 80% of energy comes from fossil fuels. A large portion of that comes from oil and gas, which are used to fuel cars, heat homes and produce electricity. Oil and gas is also a part of many manufacturing and industrial operations, such as the creation of plastic. (For more, see Oil and Gas Industry Primer.)

According to the U.S. Energy Information Agency, there is enough crude oil in the ground to meet global demand for at least 25 years. Evidently, it is important that the world look at alternatives for long-term energy needs. For now, however, there is a steady demand for oil and gas that is not going away. Although alternative energy is growing, the world still uses a ton of oil and gas, and that is not slowing down. In fact, demand continues to grow nearly every month.

Consistent demand is something to look at when investing in any industry. Demand for oil and gas products is resistant to economic changes. While demand may slightly decrease when the economy declines, demand does not dramatically drop. And, when the economy is growing, demand for oil and gas products tends to see strong growth as well.

Produce Steady Cash Flow

Thanks to the massive global appetite for oil and gas, companies that produce these commodities not only encounter near-certain demand for their products, they can also estimate operating margins on a daily basis. To do this, companies factor in market oil and gas data as well as company production costs. Since oil and gas companies operate with such reliable data, they can plan for drilling, production and refining costs. Consequently, these companies will know their exact breakeven point and how much profit will be generated by normal operating activities.

When oil and gas prices rise, these companies see meteoric profits. When prices fall, profits may slip, but the industry can still operate with a healthy profit. Free cash flow is an important metric investors use to determine how much cash a business is generating, and oil and gas companies regularly produce strong free cash flows. (For more, see: Key Ratios For Analyzing Oil And Gas Stocks.)

While I worked in the telecommunication industry, the Chief Financial Officeralways focused on unlevered free cash flow growth as the primary metric indicating that the company was on the right track. In the time I was there, the company turned around cash flow from negative to positive. When that happened, the stock price quickly increased. The ability to increase the value of a company is a major focus point for private equity investors.

High Barrier to Entry

Getting started in oil and gas production is expensive, requires specialized equipment and calls for an experienced and knowledgeable team. Finding new oil and gas reserves, drilling, extracting, transporting and refining is cost prohibitive unless someone has billions to invest.

In addition to the cost and experience required to start an oil and gas company, federal, state and local regulations make it very difficult to produce oil in the United States. Each country has its own regulations, and in general they promote an existing state monopoly or another  established producer.

Less competition means more profits, and private equity investors appreciate less risk when investing. Warren Buffett famously prefers to invest in companies with a large economic moat, which is another term for a high barrier to entry. Some industries, such as apparel companies, have a very low barrier to entry. The barrier to entry for oil and gas extraction and transmission gives existing companies a serious advantage over new entrants.

Volatile Pricing Leads to Trading Profits

Oil and gas producers make money selling their products at market-established prices. With dedicated teams monitoring those prices on a constant basis, these companies work to take advantage of fluctuations to sell at the best price possible. (For more, see A Guide to Investing in Oil Markets.)

Producers can estimate their production ahead of time and sell their oil and gas before it is produced using forward contracts. Companies can then lock in their profits when prices are high and keep larger reserves when prices are low.

Timing the market does not always work perfectly, but it is an additional method oil and gas companies have to limit risk and lock in profits.

Act as an Economic Hedge

Consumer demand is a factor in determining the price of oil, but overall it fluctuates according to commodity prices. When other stocks go down, it is possible that oil and gas stocks will continue to perform well due to the nature of the business.

If the private equity company wholly owns an oil and gas company, the oil and gas business could still generate the same profits even if other investments perform poorly. This added diversification is a protection, or hedge, against other losses.

A hedge is an investment that has expected performance that will counter the possible downside risk of other investments. In your own portfolio, you may achieve a hedge through good diversification and investments in gold, Swiss Francs, or other common hedges. Because private equity invests on such a large scale, it may use an entire company as a hedge.

The Bottom Line

Oil and gas companies are a cornerstone of the world economy. Their products are part of the engine that powers many other industries, and products that impact our daily lives.

Private equity investors are always on the hunt for businesses with strong profits that are resistant to economic downturns and have little risk for new competition. With those criteria, oil and gas is a winning industry.

As an individual investor, it is important to understand the risks of each stock you buy, and oil and gas companies do have some risk from fluctuating commodity prices and disasters. Nevertheless, this is a great industry to invest in for solid, long-term returns as a part of a well-diversified portfolio.