A look into the risks associated with oil and gas securities
Commodity-dependent stocks have various risks, of which some investors are not aware. The two specific commodities that are fairly risky at the moment are oil and gas. Most individual investors (not firms) are currently buying shares of any solid energy sector stock that they can find. This type of bottom feeding is a recipe for disaster if you are holding the wrong stocks. Since oil and gas have shown no signs of a bottom, any stock dependent on these commodities is just as risky as the commodities themselves. Therefore, you must take into account the risks of the individual commodities when looking at the companies that depend on them.
There are four major risks when it comes to oil and gas:
- Cost risk;
- Geological risk;
- Political risk; and
- Supply and demand risk.
Cost risk is essentially the risk that goes hand-in-hand with drilling and extracting these commodities. Although professionals run these oil and gas companies, all they can do is estimate how much an extraction will cost. It is very easy for these companies to just pack up, restart and drill somewhere else. Believe it or not, this is a very frequent occurrence for oil and gas companies, it is very costly.
The next risk is geological risk, which is fairly simple. A large majority of oil and gas reserves are already fully-tapped. Geological risk goes hand-in-hand with operational costs risk because if the company’s analysts predict how much oil and gas can be extracted, the project will most likely fail.
The most obvious risk is political risk. Political risk takes into account that at any point an external political factor could greatly affect the overall oil and gas supply.
Political risk drives supply and demand risk, which is the last and most important risk factor. Demand has been very unpredictable lately with oil, so supply has had to be significantly higher than usual. Therefore, prices have dropped. On the commodity industry as a whole, the lack of predictability with supply, demand and political factors has taken its toll this year, making these commodities risky.
Beyond the four major risks, there is one further factor to consider with commodity-dependent stocks, which is an interpretation that I have come across numerous times. The chances of a commodity losing all value and you losing your entire investment are miniscule. The chances of a small oil and gas company going out of business due to a commodity prices dropping significantly is very likely. As a result, there will always be a high risk for reward with these commodity-dependent penny stocks.
For example, The Bowser Report recently recommended EnerJex Resources (ENRJ), which recently took a financial hit because of the drop in oil and gas prices. However, the upside from this otherwise financially stable, commodity-dependent stock that's now trading 80% lower than its 12-month high is still very promising. So, despite the risk of continued financial woes, the reward of share appreciation following increased oil/gas prices is considerable.
All-in-all, regardless of how stable a company is, when you are investing in commodity-dependent securities, or even commodity-related companies, make sure to take into account all of the macroeconomic risk factors that are at hand. Once you weigh the risks against the potential rewards, and have done your due diligence into specific companies, then you can invest with relative confidence in a risky sector.
The Bowser Report is a monthly financial newsletter that specializes in small stocks trading for $3/share or less. Our goal is to provide the individual investor with relevant information on microcap stocks. Each month, we recommend a new company, provide information on past recommendations and report news surrounding the microcap marketplace.
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Information in this blog post may contain references to past Bowser recommendations. This blog post contains no recommendations, and instead relies on data gathered on past recommendations from sources thought to be reliable.