Summary

• Large-cap oil industry stocks present a substantial amount of risk and many haven’t performed well after a large drop in oil prices.
• Small-cap stocks in certain oil-related segments may present huge upside following a bust, but they also come with amplified levels of risk.
• Adding exchanged-trade products that track crude oil commodity prices can diversify away risk and lead to larger returns as prices recover.

Overview

Oil prices have dropped drastically in the past few months, and now is the time to capitalize on the famous investment adage of buy low, sell high. There are many ways to invest in the oil side of the energy market. Some of these options are priced low and posed to return to their highs, while other investments offer plenty of future downside or very uncertain amounts of upside.

Crude Oil nears January 2009 lows

Crude Oil is currently 56% off of its 52-week highs from mid-summer. The commodity is also still 15% above its January 2009 lows. Cheap oil prices will likely bolster some companies in the oil sector while simultaneously weighing on the profits of others. Trends and macro-environment comparisons in the oil market bust of 2008 will be an indicator of potential outcomes in 2015 and beyond.

Source: stlouisfed.com

Large-Cap Manufacturing Segment

The large-cap oil manufacturers and marketers like Exxon Mobil (NYSE:XOM ), Chevron (NYSE:CVX ), and Shell (NYSE:RDS.A ) are the stalwarts of the US Oil Energy sector. They present all of the benefits of a well-diversified blue-chip stock, but also potential upside as oil rebounds. The sticking point for these corporations will be determining their low points.

Exxon Mobil is currently 14% below its 52-week high. For a Blue Chip with strong technicals that would indicate a strong buy scenario.

Source: stockcharts.com

However, following the 2008 oil market bust, Exxon did not recover well. In fact it fell almost 11% from mid-January 2009 to mid-January 2010.

Over the same 12 month time period Chevron and Shell, posted 9% and 12% returns respectively. Nonetheless, these returns fell short of the Dow Jones average which return around 30%. These trends indicate that large-caps present limited risk following an oil market bust, but they also present limited upside.

Large-Cap Exploration Segment

If the big oil manufacturers did not offer great returns then who did in the year to follow the 2008 bust? It was the explorers. Companies like Schlumberger Limited (NYSE:SLB ) made great returns even on the heels of cheap oil. In 2009 the stock return was almost 80%.(click to enlarge)

Fueling this return was not the cheap oil prices. It was part technology and opportunity advancement, made possible in part by less expensive oil, but also by general progress. It was also part function of technical valuation. During the 2008 oil bust, Schlumberger took a major hit losing more than half of its value.

And as history always repeats itself, Schlumberger is now down 33% compared to its 52-week high.

Large-cap exploration companies may provide the blue-chip risk protection and even greater profits than the manufacturers in 2015 and beyond. However, there is still risk associated with recreating the same ingenuity and environment that fueled the 2009 rebound. If technology doesn’t continue to propel exploration and the macro-environment continues to threaten new ground then risk and limited returns could be in the year ahead.

Small-Cap Exploration Segment

On average, small-cap exploration companies would generate better returns than large-cap companies, but if there is risk in the segment, that risk would likely affect small-cap companies’ returns even more. Fortunately, the market has already priced out more of these risks with the small-caps. Fueling the current small-cap prices is likely both concerns with their ability to handle the lower oil price or with their ability to make it in a segment with growing competition and shrinking opportunity.

Companies like Fairmount Santrol (NYSE:FMSA ) and TransGlobe Energy Corp (NASDAQ:TGA ) have seen their stock prices fall 65% from their 52-week highs and are trading at 6.6 and 3.4 current P/E ratios.

Showing strong technicals and potentially even greater upside make small-cap exploration companies even more lucrative than their large-cap counterparts, but they also pose slightly greater risks and could struggle with weathering the bust if oil prices stay down over an extended period.

Commodities

Commodities respond and react to macro-level market forces, but tend to forego those micro-level risks individual companies experience with on-going operations. This behavior means that most of that risk that could threaten Exxon, Schumberger, and TransGlobe doesn’t threaten the oil market. If oil prices stay low, that doesn’t mean the return on oil prices will be a threat, rather they will stay stable. If technological advancements hamper exploration instead of prices dropping further, the price of oil is more likely to rise.

Above all else, investing in the commodity also offers some of the best upside potential since its currently trading 56% below its mid-summer high.

Exchange-traded products like the United States Brent Oil Fund (NYSEARCA:BNO ) and the United States Oil Fund (NYSEARCA:USO ) track the spot prices of Crude oil and oil-related products like gas and diesel. (click to enlarge)

Source: Stockcharts.com

If oil prices return to $100 a barrel that would translate to over 100% return on the investment. Rest assured, you can do even better than 100% return by investing in a leveraged exchanged-traded products like VelocityShares 3x Long Crude ETN (NYSEARCA:UWTI ). The product tracks the return at about 3x that of the WTI Crude spot prices. Meaning that the ETN has dropped over 90% since Crude’s mid-summer high. However, if prices return to that $100 level, returns could near 300%.

Investing in commodities and leveraged exchange-trade products come with their own set of risks including additional inflation/deflation exposure and exchange rate risks. Leveraged products also amplify these risks just as they amplify returns.

Conclusions and Investment Strategy

Key to investing after the 2014 oil bust is a diversified portfolio, by using exchange-traded products you can mix the commodity into your overall portfolio, this could potentially diversify away some risk and potentially bolster future returns. Also, it will be impossible to predict the bottom of the oil market. However, given the 50% and historic low prices, it may be time to begin to start. By dollar cost averaging the investment over the next few months, you can insure you have purchase the commodity at an overall cheap price, and position your portfolio for the rebound.