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This article appeared in the July 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Understand the basics of picking the best oil and gas shares.

Photo of Grant Craighead By Grant Craighead, StockResource

World oil demand is in excess of 80 million barrels a day, which at spot pricing makes it a massive US$6-7 billion-a-day business. It is little wonder the sector attracts close attention from investors, but be aware that risk and reward invariably go hand-in-hand.

Supply is dominated by the Organization of the Petroleum Exporting Countries (OPEC), which accounts for about 45 per cent of global annual production, and demand is dominated by North America with about 27 per cent of total consumption. To put Australia into context, it accounts for just 0.6 per cent of global supply and 1 per cent of demand.

Australia is a net exporter of energy products (particularly coal and LNG), but is not self-sufficient in oil. Oil production peaked in 2000 and has steadily declined since, a trend expected to continue into the foreseeable future, thus adding to Australia's oil deficit. However, Australia's gas production continues to grow, meeting domestic and export demand (through LNG sales). Over the next few decades, the share of natural gas in primary energy consumption is expected to increase from 22 per cent to 33 per cent.

Gas has a key role in Australia's economic future

Natural gas will play an increasingly important role in the future economy of Australia, which has the most ambitious LNG plans of any country. Already, Australia is the world's sixth-largest LNG exporter with about 10 per cent of total trade, and the Asia-Pacific region is the largest and fastest-growing market - more than 68 per cent of global LNG trade. Japan and South Korea are the largest importers, and China and India are expected to become major LNG markets in the near future.

The source of the majority of Australian oil and gas production is offshore Western Australia, and there is significant production in offshore Victoria. The number of exploration wells drilled in Australian waters has remained relatively steady over the past two decades, while the number of onshore wells has declined.

Time and cost advantages

A major factor differentiating oil and gas from the remainder of the resources sector is the risk and cost structure. Exploration drilling, particularly offshore, is expensive but discoveries can generally be brought on-stream quickly and often have a relatively low operating cost structure. This contrasts with a major base metal discovery, which can take 10 years through development to initial production.

Hence, share price leverage to exploration success is generally much higher for the oil and gas industry than elsewhere in the resources sector.

Energy makes up about 7 per cent of ASX by market capitalisation but this includes a broad range of industry participants, such as coal producers, uranium companies, and gas and electricity distributors. Therefore, the availability of pure oil and gas companies is somewhat limited.

There is a wide range of investment opportunities - large producers such as Woodside and Santos, mid-tier producers such as AWE and Beach Energy, and junior explorers. Larger companies provide a diversified operational base, thus defraying risk for investors, although this means the leverage to any individual exploration or development activity is also diminished. At the other end of the spectrum, capital constraints often mean smaller companies concentrate on a limited number of prospects within a specific basin, retaining tremendous leverage (positive or negative) to periodic drilling of high-impact wells.

Analyse investment strategies

As with all investment opportunities, investors need to identify the specific reasons behind investments in the oil and gas industry. Typical investment strategies revolve around:

  • Dividend yield from large diversified producers or utilities.
  • Potential capital growth associated with an expected increase in the oil price and/or new project developments for existing producers.
  • Higher-risk investment associated with potential unconventional oil and gas production, such as coal-bed methane gas or shale gas.
  • Speculative investment in junior explorers participating in high risk/high return wildcat wells.

Oil price movements are obviously a key factor determining the earnings and share price of energy companies. World oil prices are quoted in US dollars and can be influenced by a multitude of factors. Some tend to be short term, such as movements in exchange rates, financial markets, and weather; other factors are longer term, such as expectations of future demand and production decisions by OPEC.

During the past decade, oil prices reached a peak of more than US$140 a barrel in 2008, as demand soared before the onset of the global financial crisis - then fell to well below US$40 a barrel in early 2009 because of a collapse in demand. A combination of reduced supply from OPEC and anticipation of economic recovery reversed the trend in mid-2009.

However, prices have been trapped in a sideways pattern of US$70-80 a barrel during 2010, with recovery in demand being slow and uncertain in major developed economic regions such as North America and Europe.

The key risk factors

In general, growth from rapidly emerging Asian economies, such as China, underpins a positive long-term demand and pricing outlook for oil, but this scenario is not without risk.

Key risk factors that could disrupt global financial markets are the European debt crisis, the pace of the US recovery, and government efforts to deflate the property bubble in China. Overall, the pace of global economic recovery and growth will continue to be the dominant factor driving energy pricing for some years.

In the longer term, government policies and rising oil prices will provide incentives for continued development and use of alternatives to fossil fuels. The role played by petroleum-based liquids could be further challenged if electric or natural-gas-fuelled vehicles begin to enter the market in significant numbers. Rising oil prices, together with growing concerns about climate change and energy security, are leading to increased interest in alternative-fuel technologies.

Spectacular turnarounds

As noted, investment in the oil and gas industry is a high-stakes game - full of risk and reward. Global industry leader BP Oil is a stark example. It has generated annual earnings around US$20 billion or more during the past five years, returning strong dividends to shareholders. Theoretically it is a relatively low-risk investment in the sector. Yet its share price has been halved and dividend wrecked within months as the catastrophe has unfolded in the Gulf of Mexico.

Among junior companies, Queensland Gas was trading below 20 cents a share in 2005 when it became an early mover in the emerging coal-seam gas sector and established a strong tenement position, from which it began building its reserve base. Three years later it was taken out by BG Group at $5.75 a share - a thirty-fold return for investors.

Exploration success can provide similar spectacular returns, particularly in frontier environments, which represent the ultimate risk/reward trade-off. One example is Hardman Resources. It was trading around 4 cents when it established an interest in exploration tenements in offshore Mauritania. After attracting strong joint-venture partnerships for the prospects, its share price started to rise, with a tenfold increase once the first well was spudded. A further tenfold increase followed a series of oil and gas discoveries. The company was taken over in 2007.

The oil and gas industry, along with the broader Australian resources sector, provides tremendous leverage to the economic growth from China and other rapidly expanding Asian economies, making it a cornerstone component of any investment portfolio. But there are many specialist aspects to understanding its risk-and-reward attributes.

About the author

Grant Craighead is managing director of Stock Resource, a leading investment newsletter specialising in resource companies.

