OK – so now that you get the supply and demand dynamics behind the oil and gas markets and how prices are determined, how do you go about investing in the sector? The first (and most obvious) method is to invest in individual companies. Before you dive in, however, it’s worth knowing the most important drivers of a company depending on where it sits in the energy value chain.

The key factors determining upstream companies’ profits are production volume, oil and gas prices, and operational efficiency. Rising prices increase all of these companies’ revenue – and upstream firms can grow this further by upping their production volume. Furthermore, the leaner and more cost-efficient a company’s drilling operations are, the more profit it can make from every dollar of sales. Still, of these three, oil and gas prices are the most important.

The most common reason for investing in upstream companies – also called exploration and production (E&P) companies – is as a bet that oil and gas prices will go up. But if they end up heading south instead, E&P companies’ stock prices can get slammed. Investing in the E&P sector is therefore risky – and should be approached with caution. (One silver lining, perhaps, is the potential to snatch up some of these companies more cheaply as an increasing number of big “institutional” investors divest from hardcore fossil-fuel stocks).

As for midstream companies that transport oil, gas, and finished products, the most important thing driving revenue is volume. The more oil and gas a midstream company moves around, the more money it’ll make because it usually gets paid on a per-unit basis. This makes midstream companies less sensitive to oil and gas prices – although higher prices obviously incentivize E&Ps to produce more, leading to higher transportation volume.

Successful investing in the midstream sector involves identifying those companies that stand to benefit from future volume growth and getting ahead of the game. Alternatively, you can invest in the sector for its income potential. Because midstream companies’ earnings are volume-driven and sometimes regulated (similar to utility companies), they’re relatively stable – and allow firms to pay investors a consistent dividend. Another successful investment strategy therefore involves finding midstream players with attractive dividend yields which can be sustainably supported by their operations. Companies that can grow their dividend are even better, natch…

Finally, downstream companies that convert raw oil and gas into usable products benefit when the “spread” widens between the cost of their inputs and the price of their outputs. For example, if oil prices are falling but gasoline shortages are driving prices up at the pumps, refineries will see their margins expand and their earnings boosted. Another key variable is the “utilization rate”, a.k.a. the percentage of time a refinery is running. A business that can maximize this – by, for example, reducing maintenance time or avoiding unplanned outages due to accidents –will make more money from its operations.

Regardless of the type of company you’re investing in, you can do so by picking individual stocks or by using exchange-traded funds (ETFs). For example, if you think oil and gas prices are headed up, you can buy an ETF tracking a basket of E&P companies (e.g. XOP) or oilfield services firms (e.g. OIH) – the latter would benefit from increased drilling activity if energy prices are higher. If you want to be more conservative, meanwhile, you can invest in diversified energy companies – big businesses “vertically integrated” across the entire energy value chain. Because of the broad nature of their operations, these companies are less sensitive to energy price movements. Still, the midstream is even less sensitive – and these firms also tend to have higher dividend yields. MLPX is an example of an ETF that tracks midstream companies.

Of course, you can also invest directly in energy commodities instead of energy companies. Why not simply buy oil if you think its price is going up, instead of buying E&P companies and introducing a bunch of other variables into the equation? You can indeed invest in oil and gas through futures contracts – but you need to proceed with great caution, due to the inherent leverage involved futures – and because oil and gas prices tend to experience big moves fairly frequently.

Alternatively, you can invest in an oil ETF (e.g. USO) or natural gas ETF (e.g. USG). But be warned: these don’t perfectly track oil and gas prices, thanks to fees and the fact they too invest in futures contracts rather than the physical commodity. And since futures contracts have expiry dates, these ETFs have to constantly reinvest funds into newer ones. This constant “rolling” of futures means the ETF’s performance will deviate from the underlying energy commodity.

And that’s that: now you know all about the energy industry, you can roll out the barrel and get involved. Let us know how you get on!

In this Pack, you’ve learned:

🔹 The energy industry includes upstream, midstream, downstream, and oilfield services branches. And while it’s undergoing some profound changes, it’s still an investment worth considering.

🔹 OPEC, the world’s most influential oil-producing body, has been losing market share to US shale. But natural gas, produced in much the same way as oil, may be the next big battleground.

🔹 Oil demand is largely driven by transport fuels, facing an emerging threat from EVs. And gas demand is mainly driven by the power sector – fast transitioning towards renewables, albeit with natural gas an important transitional back-up for now.

🔹 Oil and gas prices are determined by supply and demand factors in the long run – but seasonal trends, inventory levels, speculators' actions, and geopolitics all influence short-term prices.

🔹 You can invest in individual companies at different points of the value chain, or in ETFs that track groups of those companies. Alternatively, you can invest more directly in oil and gas through futures or ETFs – but you should do so with great caution.