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3 things every oil investor must know

Shares in big oil producing companies including Oil Search Limited (ASX: OSH), Santos Limited and Senex Energy Limited (ASX: SXY) have fallen back in the last month.

However before taking advantage of falling share prices there are three things every current or prospective oil investor should know:

1. Oil price volatility has dropped

According to Reuters the volatility in oil futures has fallen to around the lowest levels since the early 1980s. Benchmark Brent crude oil has traded in a range of $5 either side of $110 per barrel since mid-2012.

One of the key reasons is the boom in shale oil production in the U.S. and around the world. This has had a duel effect of reducing fears oil supplies are coming to an end, while spreading the global production. Globally diversified production has reduced the power previously held by OPEC nations and reduced volatility in the same way that a diversified investment portfolio spreads risk and reduces volatility.

2. How much oil do they have?

It’s important to understand how much oil (or gas) a prospective company has so it can be compared to others of the same calibre. ‘Reserves’ represent the amount of commercially recoverable oil and gas a company has, which has three grades:

1P (Proved reserves)

2P (Proved + probable reserves)

3P (Proved + probable + possible reserves)

1P is the most accurate forecast of ‘proven’ reserves, which stand at least a 90% chance of being recovered. 2P is the sum of proven reserves, plus less certain ‘probable’ reserves, while 3P is the sum of proven, probable and ‘possible’.

According to the American Society of Petroleum Engineers (SPE), the best estimate of energy recovery from a project is generally considered to be the 2P figure. This is also the figure to use when comparing companies, for example using the EV/2P (enterprise value (EV) divided 2P reserves) ratio, which identifies companies that are cheap relative to their 2P reserves.

3. How are they funded?

Oil companies can be high margin and cash rich, but it is essential to understand how the company plans to fund its next round of growth projects. Debt can wipe out a company with no existing oil/gas production to sell, but relying on shareholder equity may mean continued capital raisings requiring you to stump up cash.

An ideal structure is a self-funding one, where the company establishes early well production that then funds future growth. This is the model being adopted by Cooper Basin oil producers like Senex Energy and Drillsearch Limited (ASX: DLS).

Foolish takeaway

Understanding the dynamics of volatility, knowing how much energy a company has and working out its capital structure are three key factors to evaluate when picking a winning oil company to deliver you strong future earnings.

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Motley Fool contributor Regan Pearson owns shares in Senex Energy Limited.