Oil is in a demand "super cycle", which makes high-risk, high-reward investing in oil exploration an attractive option. Some analysts, however, say it borders on speculation.
Junior oils can be a major find
As oil accelerated past the US$110 (Dh404) mark last week, many investors are looking to profit from the price spike. If it hits $200 a barrel, as renowned commodities investor Jim Rogers recently predicted, many more will wish they had.
You may already be exposed to the fortunes of oil majors such as BP, Exxon and Royal Dutch Shell, either by directly investing in their shares, or indirectly holding them in a mutual fund.
There is another, bolder way to play the rising oil price: investing in the shares of small oil and gas exploration and production (E&P) companies, sometimes called junior oils. These smaller oil industry players can be a lot riskier than their seniors (investors in BP may disagree), but they can also be a lot more rewarding.
Junior oil companies roam the globe, panning for black gold. If you hold shares in a company that strikes it lucky, you could be onto a gusher. But if its well turns out to be dry, your portfolio could look pretty parched.
Desire Petroleum recently showed how volatile this sector can be. On December 2, its shares leapt 24 per cent after it prematurely claimed to have found oil in its Rachel prospect, in the North Falklands Basin. Days later, the shares sunk 50 per cent when the prospect turned out to contain mostly water. Subsequent disappointments at its Jacinta and Dawn prospects knocked a further 30 per cent off the share price.
The AIM-listed Rockhopper Exploration, another firm drilling in the North Falkland Basin, has seen its share price zigzag between a low of 37 pence and a high of 510p in the past 12 months. It is currently trading at 355p. Given the risks, are you bold enough to bet on black?
On Tuesday, the price of a barrel of Brent crude was nudging past $110 a barrel, up from $35 at the depth of the credit crunch. But it is still a long way from its $147 spike in the autumn of 2008.
The increase has been fuelled by the recent Middle East unrest. But other short-term factors have also come into play, such as cold winter weather in the US and Europe, a drop in stockpiles and the closing of a major pipeline pumping oil from Alaska, says Dan Dowding, the chief executive (Middle East and Asia) at IFAs Killik & Co in Dubai. "The weak US dollar is another factor. Oil is priced in dollars and as the dollar sinks, the price rises."
But in the long-term, the price is heading only one way - upwards. "Emerging markets are on a roll. With 87 per cent of the world's population and 52 per cent of global GDP, they are now the major players in the global economy. Their thirst for oil and other commodities is expected to push demand up to a record 88.6 million barrels per day."
Mr Dowding invests his clients' money in integrated oil majors, including Exxon, Shell, Statoil and recovery play BP, but says now is a good time to go prospecting for smaller E&P companies with a big future.
Oil is in a demand "super cycle", he says, driven by rapidly industrialising China, India, Brazil, Russia and the Middle East, but the oil majors may not be the best way to play this. "Their reserves are declining, and they also have to make large investments in 'downstream' activities such as storage, transportation, refining, chemical processing and distribution, which don't directly benefit from rising oil prices."
Smaller oil explorers, by comparison, directly benefit from rising oil prices. It boosts the value of every barrel they pump out and the value of any fresh reserves they discover, and makes them juicy takeover targets for oil majors hungry to boost their own reserves.
Mr Dowding has been a long-term investor in companies such as Cairn Energy and Tullow Oil, both of which have grown into FTSE 100 companies, and Premier Oil, now firmly in the FTSE mid-250. He is also targeting smaller E&P companies such as Rockhopper, Excite Energy and Dragon Oil. "Investing in junior oils isn't for the faint-hearted," Mr Dowding says. "Share prices can be hugely volatile, but also hugely rewarding. You can spread your risk by diversifying into several different companies."
Some analysts refuse to even talk about investing in junior oils. Clem Chambers, the founder of the stocks and shares website advfn.com, flatly refused to discuss the sector, claiming it is so risky and murky that private investors will probably be left all at sea.
Tony Shepard, an investment analyst at the stockbroker Charles Stanley, agrees that smaller oil companies are too risky for most private investors and prefers to stick to reliable oil majors such as Royal Dutch Shell, which he says is attractively valued and yields a generous dividend income of 5 per cent a year.
Investing in oil exploration companies borders on speculation, but has handsomely rewarded those who know what they are doing, says Mark Dampier, the head of research at Hargreaves Lansdown, one of the UK's largest independent financial advisers. "The oil majors haven't got as much reserves as we think. It is up to the second-line explorers to find oil and their shares have performed strongly in recent years."
We live in the oil age, Mr Dampier says. "There simply is no substitute. We use petroleum compounds to make plastics, lubricants, electricity, toothpaste, shampoo, soap, perfume, fertilisers, pesticides, petrochemicals and asphalt, and transport all these goods around the world. We can't wean ourselves off oil until we have found an affordable replacement and we're nowhere near there yet."
Oil is getting harder to find, and more expensive (and dangerous) to extract. "Most new finds provide just a day's global use of petrol," says Mr Dampier. "I couldn't tell you whether oil will cost $50 or $200 a barrel in future, but one thing is certain: we aren't going back to the days of $10 a barrel."
But it isn't a one-way bet. If the China growth story has an unhappy ending, for instance, the price could plunge. And it may have been artificially pumped up by the US Federal Reserve's latest bout of quantitative easing (QE2), which has led to a flow of hot money into commodities, including metals, energy and oil.
Any private investor who puts a large chunk of money in a single oil explorer is taking on massive risk, Mr Dampier says. "It won't make any money until it strikes oil. If it strikes water a couple of times, it could go bust. A safer alternative may be to invest in a specialist mutual fund such as the Junior Oils Trust."
The Junior Oils Trust, a UK-based unit trust from Capita Financial Managers, invests in E&P oil companies and has performed strongly in recent years. It has returned 49 per cent over the past 12 months, 51 per cent over three years and 85 per cent over five years, according to figures from trustnet.com.
The fund's manager, Angelos Damaskos, says he reduces risk by avoiding "pure exploration" activities. "It costs around $25 million to $30 million to test a prospective well, especially in deeper water, and the odds of striking oil are just eight-to-one. Any failure can have a massive impact on a company's balance sheet and its ability to raise extra money in future. We focus on companies that already have some oil reserves and are looking to expand them. That way, a disappointing drilling result doesn't have to be a catastrophe."
The fund invests in up to 40 different companies and its top five holdings are Caza Oil & Gas, Premier Oil, Encore Oil, Dragon Oil and the Norwegian Energy Company. "Even if a private investor builds a portfolio of five different E&P companies, they are taking on a large amount of risk," he says. "Even larger companies have had disappointing results."
The fund's investors must also prepare themselves for volatility. "Nothing moves up in a straight line, even the oil price. But the trend has been positive for a decade and I expect that to continue well into the future," Mr Damaskos says.
With Exxon projecting that annual global oil demand will hit 100 million barrels per day by 2030, the oil age still has a long way to run. It could prove a rewarding journey for investors, provided they do their research carefully, take advice where necessary and brace themselves for a bumpy ride.