The energy sector provides unique opportunities for individuals interested in investing, especially with companies that operate under the oil and gas drilling category. The oil and gas drilling sector focuses on the companies that explore the world for the reservoirs of raw materials that can be refined into usable oil and then drill to extract that material. In the oil industry, this is known as the "upstream" part of the business.

There are many companies solely dedicated to the exploration and production of oil, however, many large companies are involved in all aspects of the oil industry. These companies are known as integrated oil companies, the "supermajors" or "big oil." Examples of big oil companies include Exxon, BP, and Shell.

To determine whether a company is appropriate to add as an asset class within an investor’s portfolio, it is necessary to calculate certain ratios, to fully understand the financial position of a company, as well as its long-term prospects. One of the more important financial ratios to consider is the price-to-earnings ratio (P/E ratio).

P/E Ratio

The P/E ratio of a company or specific industry gives insight into the value of that company or industry by comparing its current share price to its per-share earnings. The P/E ratio is calculated by dividing the market value of a company's shares by its earnings per share (EPS).

P/E Ratio = Market value per share / Earnings per share

The ratio is typically calculated using share price information from the previous four quarters and analyzed to determine the relative value of a company's shares to its peers in the industry or to a specific benchmark. The P/E ratio helps determine if a stock is overvalued or undervalued.

The P/E ratio can also be used as a projection tool by using expected estimates for the upcoming four quarters. Whether for current or future calculations, a high P/E ratio typically means that shareholders can expect growth on earnings that are higher than companies with lower P/E ratios, but only when compared to companies within the same sector or industry.

Oil and Gas Drilling P/E Ratio

As of Q4 2019, the average P/E ratio of the oil and gas drilling sector is 16.98. The industry average includes the metrics of large-, mid- and small-cap companies.

Historically, U.S. stocks have had an average P/E ratio of 16.5, which puts the oil and gas drilling P/E ratio in line with expectations. However, many analysts argue that the P/E ratio is not the best-suited ratio for the oil and gas sector.

This view is taken mainly because the oil and gas drilling sector requires a lot of capital expenditure for the tremendous amount of machinery involved in the business. When oil prices are low, companies cut back on capital expenditures, when oil prices are high, they invest in capital expenditures.

Because oil prices fluctuate greatly, this makes capital expenditures volatile, which makes earnings volatile, and so makes the P/E ratio a difficult indicator for the sector. Also, many oil and gas drilling companies reinvest their cash flows into new assets, which can also throw off the valuation as a true assessment of a company's real profitability. Still, the P/E ratio can provide insight when comparing similar companies.

The Bottom Line

For investors seeking opportunities in investing, the energy sector can provide opportunities within oil and gas drilling companies. The sector is volatile, so investors should be aware of all relevant metrics, including the P/E ratio, before investing.