As we noted in our last entry, crude oil markets are subject to large price swings due to geopolitical events and economic cycles. However, we believe there are underlying secular dynamics in place driven by new demand from emerging markets and constraints on new supply that are likely to keep the average price of oil elevated well into the future. Here is a set of criteria for considering long-term investments in oil producing firms.
First, valuation should be a primary consideration. The high volatility of oil prices has its corollary in highly volatile energy stocks. This can be exploited by the patient investor waiting for attractive entry points. Second, investors should seek firms with large reserves and the ability to grow production steadily over the long-term.
Exploration and production risk is becoming increasingly acute as many firms seek to replace dwindling reserves by drilling in ever more remote, technologically challenging and expensive locations.
Finally, investors should seek out firms with the ability (and desire) to protect the interests of shareholders. The majority of crude oil reserves are held by national oil companies and many private firms operate in countries with weak legal protections and mercurial tax codes.
In our next (and final) note on crude oil we will discuss a subset of the energy industry that we believe is exceptionally well positioned for the long run.