The price of oil is rising!
Sure, the current momentum appears to be driven by short term catalysts, but it's still good news for ASX listed energy producers like Beach Energy Ltd (ASX:BPT) and Santos Ltd (ASX:STO).
In moderation commodities can add diversification to a portfolio and I've got three quick and dirty tips to help you pick a winner.
1. Understand the commodity cycle
The biggest mistake I've made investing in commodities was failing to understand where we were in the commodity cycle.
The cycle looks like this: demand starts to rise. As prices rise with it, new production starts to ramp up. Everyone wants in and eventually supply starts to overtake demand and prices fall again.
This is what happened to oil in 2014.
The oil price looks to have stabilised now, but to stand the best chance of making money you need to take a view on where we are in the energy cycle and watch for signs things are changing.
2. Know how much energy a company has
It's important to understand how much oil (or gas) a prospective company has so it can be compared to others. '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. However 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 one to use when comparing companies, for example using the EV/2P (enterprise value (EV) divided by 2P reserves) ratio, which identifies companies that are cheap relative to their 2P reserves.
3. Know how the company is going to grow
Finally, understand how an energy company plans to grow and how it will be funded. Debt can add risk to a company with no existing oil/gas production to sell, but relying on shareholder equity may mean continued capital raisings.
Woodside Petroleum Limited (ASX: WPL) plans to leverage its strong existing cash flows to help fund its next growth phase between 2022 and 2026. On the other hand, Senex Energy Ltd (ASX: SXY) will be funding its ambitious gas development through a mix of existing production and cash from new equity partners.
Foolish takeaway
Taking a view on the commodity cycle, knowing how much energy a company has and working out its capital structure will help reduce a lot of risk when picking a winner from ASX listed energy companies.
