Oil is a commodity, but it tends to trade in its own world. Equity traders must be sensitive to the commodity price of oil. Oil producer stocks are very volatile when the price of oil is volatile. The profitability of oil producers is directly related to how much oil they can get out of the ground and what the cost of each barrel is. When the price of oil declines, there is a significant impact on the bottom line of the oil companies. The more an oil company can diversify away from this commodity price sensitivity, the less volatile the stock price will be. This is the reason that many big oil companies are in the service station business.
Retail stores yield fairly consistent profits compared to oil futures. Of course, the fuel they sell is tied directly to oil prices, but service stations make wide profit margins on food, beverages, tobacco, and other products uncorrelated with oil. Because of this commodity price sensitivity and the staggering sums, it takes to get oil out of the ground and to the market, oil companies tend to borrow immense sums of money in regular cycles. As a result, oil company stocks are sensitive to interest rates.
Oil companies that have low debt loads and low production costs are the ones that traders tend to reward with the highest multiples. Traditionally, oil companies have also been subjected to huge geopolitical risks. The global oil reserves tend to be concentrated in the most unstable areas. It is worthy of note that American oil reserves are ample to supply our needs for a hundred years or more, and those are the ones that we know about.
Historically, American oil was harder to get to and thus production costs were higher. For most of the history of the oil industry, it was cheaper to pump easily accessible oil in economically backward countries where labor is cheap and environmental, and safety laws are conspicuously absent. Today that is changing. Exploration and drilling technologies have given American drillers such an advantage that they can get oil out of the ground cheaper than pretty much anyone else can, especially when transportation costs are considered.
As our pipeline infrastructure growth, these costs will go down even further. This has given rise to a new breed of small oil companies that have a distinct advantage from being small and having most of their assets in the United States. Large international firms are struggling to remain competitive in this market, and the energy sector has experienced high volatility because of it in recent times.
Energy bears are quick to point out that many of these companies have “highly leveraged balance sheets,” meaning that they have borrowed a lot of money. Low oil prices for several years have depressed commodity prices, and that lack has hurt the bottom line of every oil concern on the planet. Rising interest rates, then, are a big concern for oil company investors.
This will not be a problem if oil prices rise closer in line with historical trends, but efficient technology may hamper that. The specter of rising rates and volatile commodity prices have conspired to make oil equities a volatile investment space. Those that have bet on a rise in oil prices may be rewarded handsomely in the future if the cartels can stabilize oil prices at higher levels.