Oil & Gas aren't going anywhere

Oil and gas are sticking around for the next few decades at least. Despite the protestations, there are three key facts to consider:

• coal, and especially lignite coal is far worse for the planet than gas. Transitioning all coal-fired energy production to gas would have a massive impact on global warming.

• the real answer to the energy crisis is nuclear power, but western governments are beholden to populations who can only think of Fukushima or Chernobyl.

• oil is not just about energy generation, but is used in essential products from plastics to medicines, across the entire array of human needs.

What affects the price of oil and oil stocks?

Oil is the energy source of the global economy, and there are hundreds of warring factors driving its price up or down at any one time. Specialised oil commodity traders spend their entire professional lives attempting to understand where oil may go next.

However, the key elements to consider are:

1. Global demand and supply – this is economics 101, but it needs to be said. All being equal, decreases in demand and increases in supply will reduce the oil price, while the opposite is also true.
2. Geopolitical problems – political instability and war in major oil-producing countries can hugely impact the demand and supply of oil. Political tensions in the Middle East which could affect the Strait of Hormuz, including the Iranian Oil Crises, are good examples of how oil can be affected. Others include the COVID-19 pandemic and the Russia–Saudi price war.
3. OPEC policy-making – the Organisation of the Petroleum Exporting Countries is a powerful cartel that controls circa 75% of the world's crude oil reserves and 42% of global crude oil output. It can coarsely affect oil prices by imposing production cuts or increases.
4. Economic growth cycles – the capitalist system lends itself to cycles of boom and bust, whereby oil increases in price when demand is high in the boom periods and falls during the bust. A component of this phenomenon is inflation, whereby high oil prices feed higher inflation, which then sees consumer purchasing power fall, reducing oil prices.
5. Natural disasters – earthquakes, hurricanes and floods can unpredictably devastate the oil supply of a major producer. A good example is Hurricane Katrina in 2005, which led to a price spike when oil production in the Gulf of Mexico temporarily collapsed.

It's worth noting that trading or investing in oil stocks adds another layer of research and complexity.

Advantages of oil stocks

As oil is so closely tied to the global economy, there are many reasons to invest or trade in the best oil stocks. The most important are:

• Diversification – oil stocks, and particularly oil ETFs, are usually an excellent addition to a diversified portfolio. This is because they are rarely strongly correlated with other traditional assets, such as bonds or real estate, which reduces risk

• Income generation – the larger oil companies almost always pay out dividends, which can be particularly attractive to pensioners looking for steady income and tech-sector investors looking to diversify their risk base

• Growth opportunities – while the price of oil continues to fluctuate, global energy demands are continuing to increase with development and population growth. Further, new oil discoveries and drilling advances can act as oil stock catalysts

• Trading volatility – seismic, geopolitical and natural disaster events can have significant short-term impacts on supply and demand, creating opportunities for traders to profit from the accompanying fluctuations in oil prices

• Inflationary hedge – like the US dollar and gold, oil is a common hedge against inflation. Higher inflation is typically driven by high oil prices, which usually sees oil company profits rise alongside their share prices. This hedge worked very well for investors in the inflationary aftermath of the Ukraine War

Risks of investing or trading in oil stocks

• Price volatility – unsurprisingly, the oil industry is highly sensitive to fluctuating oil prices, which can cause oil stock prices to move erratically. For example, the supply glut in 2014 and 2015 and the COVID-19 pandemic both caused a significant drop in oil prices. These drops can be extremely fast, which can be particularly damaging when trading on leverage

• Beta volatility – the 'beta' (or volatility compared to the wider market) is often much higher than the FTSE 100 or S&P 500. This can create trading opportunities, but volatility is often a double-edged sword. Increased volatility can offer the opportunity to generate faster profits, but conversely means you can lose money quickly if the market turns against you. It's important to consider your risk tolerance.

• Dividend risk – most oil companies pay regular dividends to investors. However, falling oil prices can make it impossible to pay out the expected dividend. A good example is Seadrill, which suffered more than average during the 2014–15 glut

• Oil spills – accidents happen when drilling, but they cannot be accurately predicted and their outcome on stock price is fickle. BP's Deepwater Horizon fiasco saw the stock fall by over 50%, while Exxon fell by less than 5% after the Valdez spill in 1989

• Regulation – high oil prices tend to generate windfall taxes, which means there is a lid on profits and usually no support when oil prices fall. This effect can be damaging for both investment and oil stock prices, as these taxes often stay in place long after oil prices have fallen back to more reasonable levels

When it comes to oil and gas plays, our view is that the market is not currently capable of financially supporting explorers unless they have already secured the financing required to drill.

The reality is that exploratory drilling is relatively high risk, and arguably higher risk than exploring for copper or gold (for example). In a functional market where explorers can gain access to capital easily, then the explorers can be worthwhile investments - and indeed, when a company has already gone through heavy dilution they can become worthwhile.

A decent example of this is Baron Oil (LON: BOIL), which has an excellent potential asset in Chuditch, and has just raised capital at a substantial discount. But this remains a risk play, and it appears on a fundamental basis that producers are so undervalued by the market that it's perhaps better to concentrate on them.

There are a handful of oil producers on AIM, but the two we like best at present are Union Jack Oil (LON: UJO) and Prospex Energy (LON: PXEN). Both are revenue generating, profitable, and debt free.

UJO's part-owned Wressle field should keep delivering the cash, while the expansion into the US may deliver rocket-sized returns. PXEN is simply waiting for various regulatory bits and pieces in Italy and Spain, but the national grid connections make the company a strong buyout target in the near future.

Both companies have recently re-rated, but can be viewed as strong holds within a wider portfolio.

On a final note, the now 75% tax rate on domestic UK production is a complete, unmitigated disaster for the juniors - so once again, if you are thinking of backing a UK explorer, be aware that investment is deserting the country.