Investing in oil

By J. Saunders Wiggins, CFP®, AIF®

J. Saunders Wiggins, CFP®, AIF®

J. Saunders Wiggins, CFP®, AIF® CEO/President

As we're ending the second quarter earnings season, and getting ready for summer to end, investors are evaluating their portfolios for the rest of the year, and hopefully really for the next 3-5 years or longer. We haven't had this much volatility in quite a while - Greece and Europe, Russia, China, global terrorism, 2016 presidential race, and oil. All make for tough decisions about asset allocation and finding value.

For today, I'm going to focus on investing in oil. Why? Because when I went to Yahoo! Finance, I found the most amount of links about oil compared to any of the other topics. Even more than on China, which just devalued its currency this week.

I won't discuss why oil is where it is, or where some people think it is headed. But I will discuss the different investments that one could make in oil if it were a good fit for one's asset allocation, with the exception of derivatives such as futures. I also won't cover ETFs and ETNs, which could be investing in stocks or derivatives. Finally, I will make a distinction between volatility and risk, terms often thought to mean the same.

For general discussion purposes, there are five sub-categories within the oil sector:

  • Refining & Marketing companies
  • Major Integrated companies
  • Equipment & Services companies
  • Drilling & Exploration companies
  • Pipeline companies

Refining & Marketing companies are the manufacturers of the end products. They typically refine and transport oil products. Some well known firms include Valero Energy, Phillips 66, and Marathon Petroleum.

Major Integrated Companies are the most known and include firms such as Exxon Mobil, Chevron, BP, and Royal Dutch Shell. These firms operate their own supply chain, including exploring, drilling, extracting, transporting, refining oil, and so on. These firms tend to be able to control costs better, giving them some stability in earnings.

Equipment & Services companies sell equipment to drilling and exploration companies. As oil prices have stayed low and rig counts have decreased, the demand for products from these companies has decreased as well. They are affected by the quantity output of oil, which is affected by the price of oil. Better known firms in this sub-category include Baker Hughes and Schlumberger.

Drilling & Exploration companies buy equipment to find and extract oil in hopes of selling it for a profit. When the price of oil drops, so does the incentive to explore for, drill for, and extract oil. As a result, revenues and earnings can decrease significantly when oil prices are low. Smaller firms in the industry tend to be leveraged, meaning they have bought equipment on credit, and might not be able to repay their borrowed money. However, there are also larger companies with strong balance sheets such as Diamond Offshore, Transocean, and ConocoPhillips that should be able to withstand the low oil prices.

And finally, pipeline companies! This might the be most complicated investment in oil because there are two components that can be bought. Often, there is a management company that oversees operations of the pipeline system and is the General Partner for the associated Master Limited Partnership (MLP). The MLP is the other component that can be purchased. This means you own a piece of the physical pipeline - you're a limited partner of the asset.

Often times, the financial press touts MLPs as a great way to invest in oil. MLPs offer a nice yield - often over 6%! However, this comes with some nuances. MLPs are volatile, with the Alerian MLP Index having lost over 20% of its value in 2015 (through 08/07/2015). Additionally, MLPs are taxed differently than most investments. Income received is a return of capital - remember, you're buying a stake in a limited partnership. You're an owner of a business. As such, tax reporting is done through a K-1 rather than a 1099. You're inevitably going to have to extend your tax return and wait for your K-1.

The favorable tax treatment is offset with the painful reporting. There are other details that I won't cover - consult your CPA or tax preparer about the details of investing in MLPs. For a quick look at the difference between a management company and its sister MLP, look at Enbridge, Inc. (ENB) and Enbridge Energy Partners, LP (EEP).

Once you consult your tax preparer or CPA and understand the tax implications, make sure you talk to your financial advisor to see if oil is an appropriate investment for your portfolio. I mentioned volatility and risk. Volatility is the price movement of a holding. Risk is the probability of losing money. Risk is the probability of a company going bankrupt and you losing your investment. That's different than the price going up or down based on the price of oil or any other factor, which is volatility. If you're buying individual securities, make sure you're okay with the volatility and that you've assessed the real risk of the company. You can spread your risk by buying a basket of securities, either through a mutual fund, ETF or ETN. Each of these investments comes with its own set of peculiarities. Do your research, or hire a financial advisor that understands the differences.

Disclosure: This article was written for informational purposes only. Any stocks, industries or securities mentioned are not a recommendation or solicitation to buy, sell or hold these securities and should not be construed as such. The author of this article is invested in UBS ETRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure ETN (MLPL).

— Topics: Investments