Investing in the Global Oil and Gas Sector: A Good, Long Term Investment Strategy - Example

Student’s Name] [Instructor’s Name] [Class] Investing in the Global Oil and Gas Sector: A good, long term investment strategy Introduction In many major regions where the natural resources are harvested, there has been political and social instability over the period of time. These regions, among others, include Iran, Iraq and Pakistan. However, in retrospect of globalization of economies, the oil and gas sector has been identified as a high priority market. This has come due to the interest in investment of government of many private funded companies in the sector. The theme of development has been set to increase the production capacity of the host country’s purifying and petrochemical sector. This is being done in the framework of developing new oil and gas fields that will ensure that the market will eventually reflect a long term business opportunity making any investment secured. Oil and Gas Since nearly all business portfolios maintain stocks that have some connection to the oil and gas business, this implies that practically every investor is affected and influenced by the oil and gas business at some level. The primary concerns related to the energy sector are the large Oil Corporations that produce, process, distribute and transport petroleum. Furthermore, independent oil companies, pipelines companies, Service companies for energy, Manufactures providing infrastructure required for the production, processing, distribution and transportation are also concerns in the sector (Steven, 2002). A vast majority of the business groups include companies that consume energy and are therefore adversely affected by a sudden rise in oil prices. Even the businesses buying crude oil are affected. For such business portfolios, a more focused investment in energy in contrast to a simple approach is preferred as it could serve as a source of increased return to the portfolio as a security against the impact of rise in oil prices (Steven, 2002). There are various ways to invest in energy by for each option in it essential to consider whether a particular approach would produce results that are independent of oil prices. For instance, though an independent oil exploration and production company is affected by a change in oil prices, but its performance is determined by locating and drilling oil. On the other hand, the output on a company that buys and sells energy will have real profit and will be subject to changes in oil prices (Lehman, 1979). A closer look at the variety of investment strategies that blend the idea of secured investment with improved profits will be a better guideline in the decision of investing. The significant of the function of such strategies would be examined in the light of high price commodities. The strategies presented below operate of an apparatus readily available in the market. They will be dealt with in the order their order of risk. However, before such strategies can be examined, it is important to consider the methods by which oil and gas companies create their worth (Lehman, 1979). The oil and gas business portfolios offer high risk and high profit investment opportunities. It is therefore imperative to identify business functions that offer the most value. The entire energy business environment shares common mechanisms that create value. A good investment strategy would exploit these mechanisms in various combinations to produce optimum results. Below is a concise explanation of the mechanisms by which the oil and gas industry makes value. It is important to understand the risks and benefits involved to better understand the investment strategies (Hawdon, 1984). . For companies that buy petroleum reserves, it is important that they make a smart buying decision. The correct price bargains and proprietary and exclusive business deals go a long way to develop and the value much needed by a business characterized by a high price environment (Lax, 1988). Most firms in the oil and gas portfolio have managed to cut operating costs, enhanced the value and/or the pace of production and improved the recoverable assets to some extent. In order for make a valid claim of improvement (Hawdon, 1984), the following must be true The seller’s property is actually managed inefficiently. The seller has lesser skills than the buyer. The other bidders have not included the exact same items in their bids. By combining the value of multiple assets, higher valued packages of can be created. This enables an operator to gain by providing more attractive and economically viable offers to a larger group of companies. Most companies involved in the energy business are involved with oil or gas drilling activities. Drilling activities are categorized as infill or step-out. Infill drilling refers to “digging” new wells between existing producing wells (Hartshorn, 1967). Step-out drilling means “digging” new wells that are outside, but close to the main cluster of existing active wells. Though, drilling activities are considered as a more traditional method of value addition, but its potential is widely taken into account. The most vital value creating mechanism, in the oil and gas business is the exploration of unidentified oil fields and putting them in operation. Exploration is basically a high risk endeavor as it is difficult for an investor to estimate its outcome. Organizations with a good track record in one area may prove to be inefficient in unfamiliar environment (Hartshorn, 1967). Though oil exploration is affected by high prices, it does have the capacity to cushion the investment risks in a high-commodity-price situation. While drilling leases, rigs and trained professionals are expensive, but such a business does make a profit in the long run. Despite this, there is comparatively little investment in exploration project as investors have limited access and knowledge of exploration deals (Hartshorn, 1967). The high price environment of buying, selling and creating petroleum reserves presents high risks. This fact alone discourages many operators to commit to projects that depend on a high oil price. Most investors prefer deals with a lower long term price. Though it is not known for sure what percentages of investors stick to this kind of price discipline, however, the producer price curve is considerably different and lower than the oil and gas prices in the progressive markets (Falola & Genova, 2005). At times operators purchase energy reserves in advance to hedge the cost of future production enough to guarantee a minimum net profit. This is a common practice in the prevailing high priced business environment. As an example, a firm may not have finalized its funds but would have calculated to minute details the amount of future productions it would maintain. Though this is a rational cautious approach, it has significant consequences for investors who earn less profit from future price increases (Falola & Genova, 2005). Many production firms have planned to hedge future productions and price risks. There are examples of companies with over 70% and 80% hedge over future production and price risk, respectively. Nonetheless, it is important for investors to keep in mind that hedging alone does not assure a positive return on capital. Though hedging is pretty effective, the probability of a high price drop and/or production problems exists. Such a scenario may beat any sensible hedge. Under the above mentioned situation, the investors need to be aware of the two main facts. They are buying at prices that have been historically high and that they have secured a significant amount of money for any possible future escalation (Falola & Genova, 2005). Investors are usually offered participations in drilling programs by drilling organizations on a partnership basis. The main objective behind this offer is to raise capital to drill in a limited geographical area. The limited geographical focus, combined with the fact that drilling is a tax driven activity puts drilling operation as a high risk investment opportunity. Furthermore, earnings depend on the location of the exploration site and operating skills of the drilling company. Few investors have the ability to successfully evaluate the possible outcome. Investment decisions are generally based on character assessments and recommendations. Since most of the drilling operations are very cautious from the geographic perspective, the risks involved are somewhat reduced (Falola & Genova, 2005). The drilling programs commonly include drilling in-fills or careful step-outs from existing active oil fields. If the operation is a success, it is usually the drilling company that has the practical expertise and control of the decision to start or hold productions. They may not have a legal right to do so. The operators make more money managing operations while the investors make profit on sale of reserves (Falola & Genova, 2005). Profits on stocks are raised enabling the purchase of petroleum reserves and a build up of a company as well. Value is created by buying reserves of fuel mostly by the reserve aggregation process that leads to the formation of business ventures that have the ability to replicate the process. Usually, the process is supported by a third party that then has a potential of becoming a publicly traded companies (Lehman, 1979). Production aggregators are firms that function on behalf of clients that are usually large business concerns. They are well diversified business entities. Their scope of work involves purchase, aggregation, operation of oil and gas production and earning a revenue form current operations. They may also be engaged in low risk development drilling. Production aggregators regularly enter the business scenarios to raise capital through discrete funds. In addition they safeguard the long-term ownership position of a commodity by providing a portfolio hedge (Lehman, 1979). Royalty is the right to receive a percentage of the sale price of oil and gas drilled, usually at the location of the oil well. The recipient of royalty does not contribute to the drilling cost or operation decisions, including the decision to drill wells. The royalty rights are purchased from mineral owners by a royalty pool from funds offered by investors. The pool endeavors to expand investment to multiple geographical reasons (Lehman, 1979). It is important that the quality and life of the production, as well as developed site is kept central. In addition, future drilling projects and operations’ skills play a role in the success of a pool. Since royalty payments are a portion of selling price, they are at risk and benefit from price fluctuations. Royalty is a passive investment. Thought it does not have current revenue, extensive drilling can drive profits. Success is also contingent with operating skill and the type of explorations (Lehman, 1979). In additions to the operators, who are involved in the basic value creation functions; there are investments from other individuals and/or institutions. From an investors view point, the least important value adding mechanism to make part of his/her portfolio is exploration. More than often fund managers/investors bring in their experience and style to the investment to compliment or supplement the operators’ skill as required. They kinds of support provided ranges from finance to exit strategies (Lehman, 1979). The inclusion of mutual funds expands to infrastructure manufacturers and oil field services companies. Investments in relatively small, private oil and gas firms are comparatively less risky than drilling operations or exploration and production build-ups as they are less open to diverse regions, operating teams and business processes. Investment in a fund of funds that combines some of the top private equity funds in the energy business can be a viable option. These funds function is more or less the same way as other private equity funds of funds. Normally the FOF investments would occur in most business operations. Majority of the FOFs are incorporated by the non-energy sector. Typically there would be a 30% investment in timber (Lax, 1988). Of the many benefits for investing in the oil industry is the fact that the service firms operating in the industry may have no geological risk associated to them. Even if the oil production firms run the risk of digging up a dry hole, which will result is no gain in terms of production or profits, the service industry will still get paid for their services. Oil service companies usually do benefit form their services even if the oil patch has problems or the research done for the exploration of oil has been proven wrong (Lax, 1988). However, the problems for service firms do persist and have a string impact on the investments in their growth and getting future contracts. Government intervention is a major cause of concern for the global oil industry. The government, of a local region, may have a different economic and political setup than the origin of the oil firm. Many states are not democratic and out of them many have strong economic systems based on nationalisation. In these cases the system of investing becomes insecure and more risky as the policy may change towards oil exploration and production over time (Lax, 1988). This instability may however may only affect the oil production firms as they have to rely on very long term leases and contracts with governments to get the return on capital that they seek to justify their investment. On the other hand, the oil service firms which only have the job to either to drill or to supervise the exploration process have lesser affect form the change in political scenario as the risk lays mainly with the direct oil production firms in the industry. When a political scenario changes its state to adversely affect contracts in the local region the oil production company which has based investment ahs to suffer in terms of either lost time or additional royalty that has to be paid as compensation. This situation may also become critical if the local government fails to provide security to the oil production firm and the cost of production may go much high- reducing the return value on the investment (Lax, 1988). Although the risks in the global oil industry may be higher the returns on the every dollar that is invested in the facilities is higher as well. region specific operations of the oil production firms may no longer fond themselves competitive and qualitative as the oil reserves have to be explored at a more rapid rate. This increase in the development of oil production has been incurred by the ever growing demand of oil around the world (Lax, 1988). Oil has been the basis and the most useful foundation of many industries that operate around the world and for many coming years it will remain the same. Shipping lines, factories, air planes, cars, trucks, house holds and almost every sector, whether commercial or residential, depends on oil one way or the other. The need of oil is ever growing and till now it has not been seen as a surplus of the demand. Any risk that may increase the cost of oil production or exploration can easily be transferred directly to the consumer by an increase in price (Steven, 2002). The price increase may eventually affect inflation and monetary policies of economies but the global oil industry does not suffer to the extreme because of the strong link between the consumption of oil and the daily life routine of the people. Oil is a necessity in people’s life and this sets a major advantage for the oil industry to revamp its production and develop on its exploration as much as it can (Steven, 2002). Of the many consumption types that can and may be decreased for oil around the globe, there are still many daily consumables based on oil for which a proper or more cost effective substitute has not been introduced or researched. Oil has been drilled and excavated in the past and will be done so in the future as well. solar energy is still a long shot away in terms of commercial applications and may still not be a part of, let alone be a substitute for oil, for many coming decades (Steven, 2002). Limited partnerships, whether master or publicly traded consist mainly of energy infrastructure companies. These mostly include pipeline manufacturers and intermediate processors of oil and gas. Master limited partnerships or MLPs were formed with the idea of integrating business to in order to turn and bring out their money value of assets that frequently provided cash flows, but were under estimated by securities analysts (Steven, 2002). Conclusion The choice of strategy from investment in the energy industry depends most of all on the position that investments has in the investors’ portfolio. As an example, an investor who has strong confidence in the further increase of oil prices would want to invest in a commodity funded heavily in future oil and gas endeavors. A different investor may use the same strategy to counterbalance the impact an increased oil price would have on his privately owned company (Steven, 2002). Investors usually wish to join the oil and gas business with the idea of striking a balance between benefits from rising prices and security from risk. In this situation, the private equity funds of funds are the best option available. In addition to taking advantage from continued prices rises it also has a wide variety of options that help create value that is independent of price. The price hedging provided my many funds provide satisfactory security against risk though it may have some price risk for the investor (Steven, 2002). Large investments can be enhanced by direct investment in individual funds that have been tried and tested in operations such as production aggregation and royalty pooling that are known for their value added characteristic. Those looking to curtail the negative impact of a range of increasing energy prices can do so by investing in community funds or private equity investments in productions aggregators that are minimally hedged or through derivatives. MLP’s and energy hedge funds play a significant role in a portfolio that is free of oil and gas prices. It is important to understand the different needs and then connect it with the most suitable strategy. Works Cited Hartshorn, J. E. 1967. Politics and World Oil Economics, Praeger Hawdon, D. 1984. The Changing Structure of the World Oil Industry, Croom Helm. Falola, T & Genova, A. 2005. The Politics of the Global Oil Industry: An Introduction, Praeger Lehman, E. R. 1979. Profits, Profitability, and the Oil Industry, Arno Press Lax, H. L. 1988. States and Companies: Political Risks in the International Oil, Praeger Steven, P. 2002. Strategic Positioning in the Oil Industry, Tauris Read More