The energy industry, like other commodity businesses, has boom and bust cycles. When energy demand is high and supply is tight, oil prices rise. This, in turn, helps drilling and exploration companies, which make greater profits from their businesses. On the other hand, when demand wanes and supply is plentiful, prices fall. The fixed costs of operating the business remain constant, but profits from selling the commodity fall. Yet despite the loose correlation between energy prices and the energy business, investing in commodities such as oil is a completely different proposition than investing in oil exploration and production companies.

Oil ETFs Contribute to Confusion

With the advent of exchange-traded funds (ETFs), investors no longer need a commodities trading account to invest in oil. As of June 20, 2016, there were 15 ETFs, including leveraged ETFs, with prices linked to the price of crude oil. The largest and most liquid ETF in this category is the United States Oil fund (NYSEARCA: USO), which had $3.35 billion in assets as of June 18, 2016.

The ETF industry may have inadvertently contributed to the confusion over the difference between commodity and stock investing. Investors can buy and sell oil ETFs on the same exchanges and in the same accounts as stocks. However, there are major differences between the two investments.

Oil Companies Have Debts

Unlike the commodity, oil companies operate businesses and make decisions about their capital structure and the allocation of resources. Prior to the oil price boom that ended in the middle of 2014, oil production companies issued shares, sold non-productive assets and borrowed aggressively to add to their reserves. This led to high debt levels, which may have been manageable if oil prices remained high. However, since reaching a peak price of $107 in 2014, oil prices dropped sharply over the next two years and closed at $47.98 on June 17, 2016.

High debt levels have serious ramifications. Oil producers may not be able to generate sufficient cash flow to service the interest and principal payments on the debt. High debt levels also may choke off access to debt markets for oil companies and force them to issue new shares to raise capital. This could lead to dilution and lower share prices. Ultimately, as more cash flow is siphoned off to pay debts or as companies issue new equity, share prices could tumble a greater percentage than oil prices themselves. In essence, oil companies are a leveraged bet on the price of oil.

Downside Differences

High debt and diminished profits create existential risks for oil companies. If low oil prices imperil the ability of companies to satisfy their debt covenants, then they must restructure those debts or face the possibility of bankruptcy. As long as they don't become obsolete, commodities such as oil prices have a floor. The vital importance of oil in so many applications ensures that when prices decline too much, buyers step in to bid up the market. However, there are many companies drilling for oil, and the failure of any one company is of no consequence to the market. A bankruptcy simply means that the assets of the company are transferred from shareholders to bondholders.

Upside Differences

While oil prices have a floor, they also have a ceiling. If prices rise to irrationally high levels, as they did in 2014, drillers produce more oil and sellers drive prices lower. Although oil companies probably also have a ceiling, it may be much higher than the commodity itself. Just as leverage can be a problem for oil companies when prices decline, it can benefit oil companies when prices rise. Oil companies have mostly fixed costs for items like rigs and drill ships. When oil prices rise, incremental revenues fall to the bottom line. Higher prices translate to even higher operating margins and valuations. In addition, the operations of smaller oil companies may be even more valuable to bigger, better-capitalized competitors. Oil company takeovers can occur at significant premiums to current trading levels.

Ultimately, leverage works both ways. As a leveraged investment, oil companies have more volatility than the price of oil. While volatility can benefit oil companies tremendously in a boom market, it can create existential risks during the bust part of the cycle. For investors considering the oil markets, risk tolerance may determine their investment choice.

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