Best Way to Invest Money in Oil Stocks

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Investing in the oil industry is like fashion -- every few years or so the trend changes. One year investors can't get enough of oil companies because it seems as though new supplies of petroleum aren't in great abundance. Then there are times when we seem to have more oil than we know what to do with and the commodity's low price turns almost all companies in the space into real stinkers.

Just because the entire industry goes through the natural cyclical waves of any business that deals with commodities doesn't mean investors should avoid the entire sector. In fact, an investment in a great company at even a horrible time on the commodity cycle can crush the S&P 500. So let's consider what you should look for when investing in oil stocks and the important thing to keep in mind once you have bought into the industry.

Crave the capital creatorsThe oil business is highly diverse, with whole sub-industries along the value chain. A company's position in the oil market will radically change the drivers of that business's prospects. The reasons a refining company could be a compelling investment are wildly different from those for an oil equipment and services provider. However, there is one particular trait that all great investments in this space possess: the ability to generate cash flow in excess of their capital expenditures throughout the commodity cycle.

Almost any bonehead oil producer can make money when the price per barrel is a $150. But generating positive cash flow without having to consistently tap the debt or equity market when that same barrel of oil is at $50 is a completely different animal. When investing in the industry, look for the companies that have the financial strength, the capital discipline to invest through the commodity cycle, and a history of returning excess cash to shareholders even when times are rough. Some of the companies with these traits are the household names you would expect, but there are certainly others that aren't as well known. Here is a quick rundown of four companies that have consistently created capital over the long term.

ExxonMobil and Chevron haven't been as effective at generating excess capital these past couple years as they were in prior years, and both have had extraordinary large portfolios of development projects that have proven unproductive -- at one point more than 40% of Chevron's capital employed was tied up in nonproducing assets. However, the companies' spending habits are shrinking as these new projects come online, and if their respective histories are any indication, they will likely return to generating large cash flow in the future.
Schlumberger has carved out an impressive market share as it has focused on providing oil and gas producers with services such as seismic mapping. The company has also avoided competing with other oil services companies to a certain degree by focusing more on the international market rather than on North America.
Equipment manufacturer National Oilwell Varco has been largely responsible for one trend that has significantly improved the economics of the industry: standardization. By making standardized components for drill rigs and other oil equipment, it has reduced maintenance costs and downtime. That has built the company a massive, loyal customer base that relies on parts only manufactured by National Oilwell Varco.

Investments in companies that have a distinctive trait like the ones mentioned above will go a long way in securing that long-term cash flow needed for sustained success.

Don't sweat the cyclesHere is one major reality you need to face when investing long term in oil stocks: Far too many people put too much impetus on the price of oil when investing in the space. As oil prices fall, some investors will exit these stocks in a hurry due to the short-term impact on earnings. Conversely, the perception that we are running low on oil will send prices into a frenzy, and overzealous investors will ride the tailwinds. While earnings will indeed likely be affected by the movement of oil prices, it doesn't mean you should invest in lockstep with these movements. Instead, sometimes the best move is to simply hang on for the ride because the power of increased demand and growing drilling activity for a company that can create cash flow can outweigh the short-term concerns of oil prices.

Here's an example. In 1996, oil prices hit a peak at about $30 per barrel (adjusted for inflation). For two years the average price for a barrel of oil fell as global demand waned due to the Asian financial panic and oversupply from OPEC. An investment at that time -- the peak of a commodity cycle -- in one of the companies mentioned above would still look fantastic today compared to the S&P 500 on a total return basis.

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I'm not saying that it is easy to hang on, nor is this kind of investing right for everyone. It takes a bit of audacity to watch an investment's prospects fall for several months at a time and not do anything. However, those with the intestinal fortitude to see past the fluctuations in oil prices and focus on the fact that the world will continue to need more oil and gas for the foreseeable future, could be well rewarded.

What a Fool believesInvesting money in oil stocks isn't challenging in the sense that it takes an extreme understanding of the global oil market and where oil prices will go in the future, it's challenging because you must be prepared to hold on to your shares while acknowledging that the price of oil could go anywhere. However, those who buy companies that have a penchant for creating capital rather than consuming it will do much better over the long term -- much better than those people who continuously look to get in and out on the whims of oil prices.

The article Best Way to Invest Money in Oil Stocks originally appeared on Fool.com.

Tyler Crowe owns shares of National Oilwell Varco.You can follow him at Fool.com under the handle TMFDirtyBird, onGoogle+,or on Twitter@TylerCroweFool. The Motley Fool recommends Chevron and National Oilwell Varco. The Motley Fool owns shares of ExxonMobil and National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.