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Do Due Diligence to Manage Energy Investment Risk

The best way to manage all investment risks, including energy investments, is to make sure you do your due diligence — research all the angles of the investment you want to make before you make it. Don’t simply take an investment position because you heard about it on a finance show on TV or because you think everyone else is doing it.

Impulse buying almost always leads to more loss than gain.

Various energy investment vehicles require you to ask different questions and do diverse kinds of research.

Energy commodity futures

If you want to buy futures contracts for oil, natural gas, coal, uranium, or electricity, make sure you ask the following:

  • Where (on what exchange) does the contract trade?

  • Who else is involved in this market, and for what reason?

  • What is the length of the contract you want to purchase?

  • Are there margin requirements, and, if so, what are they?

Knowing the fundamentals of each commodity market may be the most important part of energy investing because the performance of all investment vehicles depends on the supply and demand of the resource and the numerous things that affect that delicate supply balance. Concerning each specific commodity, you want to know:

  • Which countries control the largest reserves of it?

  • What is the geopolitical situation of those countries?

  • What are the production and consumption numbers for the commodity?

  • What drives the usage of the commodity?

  • Can the commodity be economically replaced with something else?

  • Do seasonal patterns affect usage?

  • What are the commodity’s historic trading patterns?

Energy mutual funds

Before buying a managed mutual fund, you should find out:

  • Who manages the fund? What is his or her track record?

  • What is the manager’s philosophy, and do you agree with it?

  • What are the fees and how are they charged?

  • What is the fund’s goal, and does it align with your strategy?

  • What is the fund’s historic performance?

  • What investment vehicles does the fund own?

If the fund owns energy companies, you also want to do some due diligence on them as if you were directly investing in the shares of those companies.

Energy companies

Ask the following questions before buying stock in any company:

  • What is the firm’s financial health, as determined by assets and liabilities?

  • How does the company make money, and where is future growth going to come from?

  • What is the company’s organizational structure?

  • Who manages the company, and what is the manager’s history?

  • Who are the company’s competitors (peers), and how do they compare?

  • Does the company have any regulatory or legal problems?

  • How has the company performed cyclically?

You can find the answers to most of these questions in the annual (Form 10-K) and quarterly (Form 8-K) reports that companies have to file with the U.S. Securities and Exchange Commission. You can even participate in the conference calls most companies have to discuss these reports and ask questions directly to management.

Diversification

Beyond due diligence, one of the best ways to manage risks is to diversify. Not only should you diversify the types of investment vehicles you use — stocks, bonds, funds, commodities, and so on — but also the specific types of those vehicles you choose.

For example, owning oil stocks, oil funds, and crude oil futures isn’t diversification. Mix it up among types of energy. You don’t want to put all your eggs in one energy basket. Instead, you want exposure to asset classes that do well when others don’t, so you can’t get wiped out if one goes sour.

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