Energy investments have risks

Energy stocks represent approximately one quarter of the weighting within the TSX/S&P Composite Index, which isn’t surprising given the rich resources available in Canada and high demand world wide.  Everyone needs energy and power, unless you’re living in a cabin in the wilderness.  Let’s take a look at the energy sector in three categories:

Infrastructure

If investors are looking for lower-risk options in the energy sector, the first place to look is often within infrastructure.  Two names in this category that are hitting the media in 2011 are TransCanada Corporation (controversy over Keystone pipeline through US to the GulfCoast) and Enbridge Inc. (controversy over pipeline to Kitimat).  These two stocks are considered lower risk within equities.  There are numerous pipeline and infrastructure type energy investments; many of these same stocks pay a good dividend.  In our opinion, stocks within infrastructure can be traded but many are also good long term holds.  Risks within this sector are:  interest rates, power prices, age of infrastructure, natural disasters, accidents, poor maintenance, commodity volumes, regulatory approvals, and environmental legislation.

Equipment and Services

The equipment and services stocks within energy are typically higher risk.  Servicing wells and drilling can be a very profitable area when times are good.  When energy commodities decline below certain thresholds, many of these companies go into survival mode.  As an example, if the price of a barrel of oil declines below $68, many companies may stop drilling until the commodity rises in value which would hurt the equipment and services side of energy.   If an equipment and services company pays a dividend, it is often on the lower end and can fluctuate based on conditions.  In our opinion, stocks within equipment and services should be monitored continuously and traded.  Risks within this sector are:  commodity prices, labour supply, access to supplies, weather, contract risk, foreign exchange, customer concentration, political risk, and technological acceptance.

Oil and Gas

Oil and gas are perhaps the first two things that people will think of when we talk about energy.   Another term for upstream is exploration and production which essentially means that a company specializes in finding oil and gas fields under the ground or under water.  E&P also includes drilling of exploratory wells, and operating the wells to bring crude oil and natural gas to the surface.  Getting it up and out of the ground is essentially upstream. Downstream is when a company is dealing with the oil and gas once it is out of the ground.  An example of this is crude oil being refined.  Converting the raw material into products such as gasoline, diesel, natural gas, propane, heating oil, etc. are all examples of downstream activities.  The distribution and retailing of these products to the consumer is also an example of downstream.

Integrated Company

Some of Canada’s largest energy companies are considered integrated.  This essentially means that it does both upstream and downstream activities.   A company like Suncor would essentially buy land, explore it, drill it, extract the oil, refine it, ship it, and retail it.  Integrated oil companies generally have a risk classification between medium and high.   Risks include drilling program success, commodity prices, estimated reserve life, method of extraction, project execution, weather, and political and regulatory risk.

Geographic Diversification

Although Canada is rich in oil and gas many of the world’s largest fields are outside of North America.  Many Canadian oil and gas companies have operations purely within Canada.  Some concentrate within one province, while others have operations in four or more provinces.  Many energy companies listed on the Toronto Stock Exchange have operations outside of Canada.   Many investors bullish on the energy sector diversify by geographic region.  Additional risks exist for companies with operations outside Canada including political interference, foreign currency, agreements being changed or cancelled, and unfavourable changes in taxation.

Operational Mix

If a company has just oil, it would be considered a pure play oil company and it’s the same for gas.  Most energy companies are not pure play because most have fields with both oil and gas.  Depending on the prices, a company may choose to focus on one or the other.   It is possible to look at the operational mix of a company to see what assets it owns and the percentage weighting between oil and gas.

Supply and Demand

The peak oil theory is often referred to when investors are bullish on the energy sector.  With a limited supply, this theory supports that prices should rise over time.  New technologies of extraction and massive discoveries in the short term can impact this theory.  Individuals bullish on this sector also have done analysis on the growing population and the rising demand for oil and gas in emerging markets such as China and India which supports energy prices rising over time.  Over the years, fears of global economic slow downs have resulted in significant corrections to energy commodities.

Unlike material stocks, many oil and gas stocks have a decent dividend yield.  We encourage growth oriented investors to look at the dividend reinvestment plan on the energy stocks they own, as many offer discounts for participation.