What Are the Risks Associated with Investing in the Oil and Gas Sector?

Investing in the oil and gas industry carries a number of significant risks. Three of those risks are commodity price volatility risk, cutting of dividend payments for those companies that pay them, and the possibility of an oil spill or another accident during the production of oil or natural gas. However, long-term investments in oil and gas companies can also be highly profitable. Investors should fully grasp the risks before making investments in the sector.

Key Takeaways

  • The oil and gas sector is an attractive sector for both day traders and long term investors.
  • The sector is an active and liquid market that can also serve as a portfolio diversifier and inflation hedge.
  • Oil and gas stocks, however, tend to be more volatile than the broader market as they are sensitive to changes in the supply and demand of the underlying commodities.
  • In addition, oil companies are exposed to legal and regulatory risk that can be the consequence of accidents, such as oil spills.

Understanding Oil and Gas Investments

The main risk associated with oil and gas investments is price volatility. For example, the industry encountered substantial volatility in the commodity prices in 2014 and 2015 due to a supply glut of crude oil and natural gas. The high levels of supply have hurt stock prices.

In the spring of 2020, oil prices collapsed amid the COVID-19 pandemic and economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows.

The price of crude oil dropped substantially in the first quarter of 2020. Oil went from over $107 a barrel in July 2014 to around $20 in March 2020. Natural gas followed suit, going from $4.80 per one million British Thermal Units (mmBtu) in June 2014 to around $1.60 per mmBtu as of March 2020, a drop of around 70%. Natural gas is notorious for being seasonal and volatile in its price due to greater demand during the winter. However, the drop, caused by the spread of the COVID-19 pandemic and the split between OPEC and OPEC+ over production cuts, plunged prices for fossil fuels to historically low levels.

The entire sector has been hurt by lower commodity prices, not just those companies that engage in the exploration and production of oil. Oilfield service providers and drilling companies have been hurt by lower demand for their services as production companies cannot earn as much revenue because of the low prices.

Beta is a measure of a stock's relative volatility. Indeed, the betas of oil stocks tend to be higher (i.e., more volatile) than than the S&P 500 (which has a beta of 1.0). For instance, as of March 2020, ExxonMobil's beta was about 1.25; Chevron, 1.16; and ConocoPhillps, 1.5.   The beta of the energy sector ETF, XLE, is 1.02 as of Jan. 16, 2021.

Dividend Cuts

Companies in the oil and gas sector often pay dividends. These dividends allow investments in those companies to make regular income. The dividends are, therefore, attractive to many investors. However, there is a significant risk that the dividend can be cut if the company is unable to earn enough revenue to fund the payments to investors. This risk is intertwined with that of low commodity prices. If companies earn less revenue from the sales of their products, they are less likely to fund regular dividend payments, and there is a greater likelihood of a cut.

For example, Seadrill, an operator of drilling rigs, cut its substantial dividend payment in November 2014, and the price of the stock dropped by over 50%.  The cut took many investors by surprise, and it highlights the risk associated with a dividend cut. Investors in the company lost out on a regular dividend payment, and they also lost a big chunk of the value of their shares.

Oil Spill Risk

Another risk in the oil and gas sector is that an accident could occur, such as an oil spill. This type of accident can be devastating and cause a company’s share price to go into free fall.

BP saw its stock fall in the wake of the Deepwater Horizon oil spill in 2010. The stock was trading around $60 prior to the spill and dropped to as low as $26.75, a decline of over 55%. The Deepwater Horizon oil rig exploded and sank, leaving a sea-floor oil gusher that released over 4.9 million gallons of oil into the Gulf of Mexico. The oil spill had a severe negative impact on marine life and habitats in the Gulf. BP is still dealing with lawsuits and other issues from the incident years later.

In contrast, Exxon's stock did not fall that much after the Valdez incident in 1989. The Valdez tanker ran aground in Prince William Sound in Alaska, spilling over 11 million barrels of oil into the water. Exxon’s stock went down 3.9% in the two weeks after the spill, and it recovered those losses after a month. The Valdez spill physically released less oil into the water. Still, the impact of the Deepwater Horizon spill on BP's stock price shows how such an incident causes a major decline due to the availability of information in the connected age, along with the impact of the 24-hour news cycle. The possibility of any future spills or other incidents may be a larger risk than it has been in the past.