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How to Evaluate Oil and Gas Stocks for Energy Investing

Properly evaluating a future oil and gas investment is perhaps the most important skill you can learn as an investor. It can mean the difference between securing that nest egg for the future and losing your shirt because of a bad craps throw.

Instead of diving into the oil and natural gas industry and picking names out of a hat, properly assess a company’s current position to determine its future value.

    Size matters

Before diving right into the deep end, here is one piece of advice that will help you deal with the immensity of these industries: Nobody has it all figured out.

That encompasses more than individual investors like you. It goes for both amateur and seasoned investors, fund managers, analysts, day traders, and insiders as well.

When you’re kick-starting the search for a new oil and gas investment, look first at size and sector. Here’s how the size of companies is broken down:

  • Nano cap: Companies with market caps below $50 million are considered nano caps and carry the greatest risk.

  • Micro cap: These companies have a market cap between $50 and $300 million. These stocks typically cost pennies on the dollar and can be extremely volatile.

  • Small cap: With a market cap between $300 million and $2 billion, still in the speculative range, small cap stocks also carry plenty of growth opportunity.

  • Mid cap: These stocks have a market cap above $2 billion but below $10 billion, and like small caps, offer potential growth for investors.

  • Large cap: Market caps for large caps are between $10 billion and $200 billion or higher. As you may guess, these caps are at the other end of the risk spectrum. These stocks come with lower risk and are much more stable than smaller companies.

Although it typically goes without saying that you expect a small growth stock to deliver higher returns than a stock with a larger capitalization, that isn’t always the case. In fact, some of the strongest returns delivered to investors last year came from large cap stocks in the refining sector.

This figure illustrates the performance of two such investments during 2012: Marathon Petroleum (NYSE: MPC) and Valero Energy (NYSE: VLO), which have market caps of $29 billion and $24 billion, respectively.

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    Putting it all together

Every time you’re about to make a new trade, you should ask yourself several questions — a kind of inner checklist that assures you’re on the right track or warns you of a potential blockbuster mistake headed your way.

This simple checklist of things to consider can save you quite a bit of time down the road and help you do your due diligence:

  • Location: Depending on the specific sector, where the company is operating is sometimes as important as (if not more important than) who’s doing the drilling. It could mean the difference between drilling in the Bakken formation, which has fueled North Dakota’s oil boom for the past five years, and drilling one dry hole after another.

  • Assets: Whether a company is a fully integrated oil company with assets upstream, midstream, and downstream, or a small E&P company holding on to an exploration license, always take note of a company’s assets.

    For upstream activity, this could mean leases or reserves. Midstream assets include storage and transportation facilities, trucks, pipelines, or even tankers to ship millions of barrels of crude oil. Downstream assets can include oil refineries, pipelines, trucks, or other means of transporting refined oil and gas products.

  • Growth trends: Has the company managed to increase revenue in the previous year? And does it expect to meet future revenue and earnings during the next four quarters?

  • Healthy balance sheet: Is there a major debt load burdening the company? If not, what is its cash position? A company with little to no debt and the ability to fund its drilling program going forward is a good sign for future performance.

  • Attractive valuation: What is the company’s price/earnings ratio? Is it under 10? Moreover, a company with a price/earnings to growth (PEG) ratio less than 1 could indicate that it’s currently undervalued.

  • Quality of reserves: This category doesn’t usually get much attention from investors. This is probably due to the growing number of reports coming out that report production and reserves in terms of barrels of oil equivalent without offering the details.

    To use the Bakken play as an example, remember that production from that area is 98 to 99 percent light sweet crude, as opposed to an area that has more natural gas, which is sold at a discount compared to oil.

  • Cash flow problems: What are the company’s present and future funding needs, and will raising money dilute the stock?

  • Yield: Many oil and gas companies offer a secure annual dividend paid out to shareholders on a regular basis. When searching for a safe dividend, determine whether the company has increased, maintained, or even lowered its dividend during the past five years.

    Furthermore, find out the payout ratio, which is the amount of earnings paid out in the dividend. A company with a high payout ratio may not provide a secure dividend to shareholders.

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