Five essential tips to help you profit from oil and gas exploration.
Investing in 'junior' oil and gas explorers can deliver huge profits and is popular with a lot of private investors. But it's also a high-risk activity that's volatile, dangerous and can easily result in big losses.
Despite this, I believe it is possible to invest in small cap oil and gas explorers while staying close to Foolish investment techniques -- although if you're just getting started on your investing career, then I'd recommend you read this free report, What Every Investor Needs To Know, before you consider buying any shares at all.
In this article, I'd like to share a few tips with you that should help you get started on the road to Foolish oil and gas investing.
1. Do your own research
The Internet is full of people who want to convince you of the merits of their share choices. Some of these are genuinely knowledgeable, some are genuinely ignorant, and some of them are trying to ramp or depress share prices for their own gain.
It isn't always easy to sort the wheat from the chaff, and the only solution is to be very sceptical and base your decisions on your own understanding of the facts. RNS releases and company investor presentations make a good starting point -- and you will need to learn some of the technical jargon, too.
One essential way of reducing risk is to ensure that the fortunes of the companies in your portfolio are not linked.
For example, if you want to invest in Falklands oil, choose Rockhopper Exploration (LSE: RKH), Falkland Oil & Gas (LSE: FOGL) or one of the others -- but don't choose multiple companies in the same location, because most likely they will sink or swim together.
Similarly, you need enough companies in your oil and gas portfolio to dilute the impact of your losses -- because you will have some losses. I think five to ten is good, but the more you have, the more you dilute the profits from your successes.
My favourite way of reducing risk is to invest in companies that have a modest level of proven resources and are on the cusp of transforming it to something really impressive. The best flavour of this is when a company has enough cash and production revenues to fund its exploration programme, reducing its need for debt or equity funding.
A good example is Max Petroleum (LSE: MXP), which operates in Kazakhstan. Most of Max's share price is supported by the value of its current production and proven reserves, but its pre-salt exploration programme promises something much, much bigger if it is successful. However, if it isn't successful, the company won't become worthless overnight -- the fate of some small oil explorers.
4. Safety net
I suspect that some investors will disagree with this, but I like to have around 10% of my resource investment portfolio in something big, solid and reliably profitable.
For this, I look to the FTSE 100. My choice is Royal Dutch Shell (LSE: RDSB) -- which I hope to hold forever -- but other good alternatives include BP (LSE: BP) or BG Group (LSE: BG).
5. Knowing when to sell
The share prices of small cap companies with make-or-break business models are always more volatile than average. Variations of 10%-20% in a day are not uncommon with small oil companies and quite often they don't signify any material change in the company's situation. Part of the trick of investing successfully is maintaining your own judgement of the underlying story so that you can decide when to sell, regardless of market sentiment.
On the other hand, there are times when you have to seize an exit opportunity that might take years to repeat itself. SOCO International (LSE: SIA) shareholders who could have sold for 550p in 2007 and 450p in 2010 are still waiting for another chance; today, SOCO's share price is just 270p.
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Roland owns shares in Falkland Oil & Gas, Max Petroleum and Royal Dutch Shell but does not own any of the other shares mentioned in this article.