Should I buy oil shares?

With headlines about some benchmark oil prices reaching three-year highs in the past few days, is now a time to add some black gold to my portfolio? Or has the prospect of higher prices already been factored into oil shares?

Here’s my take.

The oil price cycle

It’s important to understand that like many commodity prices, the oil price is cyclical. When it gets high, demand falls back somewhat. Over time, a surplus develops, driving prices lower. That leads to less investment in finding new oil. Over time, that again leads to a mismatch between demand and supply, driving prices up again.

That cycle has been going on for a century, and I don’t see it changing any time soon. Electric vehicles may catch the headlines, but oil has far more uses than just being refined into car petrol. Many such applications currently have no cost-effective alternative fuel source. As the world population grows and developing markets get richer, I actually expect oil demand to keep rising. But last year, many oil companies made savage cuts to their exploration and development budgets. For example, Exxon deferred over $10bn of capital expenditure in 2020. Down the line, such swingeing cuts will likely mean less capacity, which could drive up oil prices.

Oil shares and diversification

One reason I often stay away from oil shares is that they can be so affected by oil price shifts. Even though companies such as Shell and BP have been talking lots about diversifying their income streams, changes in the oil price often move their shares. Last year, when I held Shell, I was dismayed that it cut its dividend for the first time since the Second World War after only a fairly short period of depressed oil prices. Its recent big dividend hike makes me think management acted too hastily. Oil price fixation can lead to short-termism in the industry, affecting shares.

As I have no crystal ball when it comes to oil prices, that makes oil shares less attractive to me. When they are cheap, though, I sometimes add some to my portfolio for their dividends. BP, for example, currently yields 4.4%. If I had bought it last November while its price languished, my yield would have been around 8%.

I also think diversification is an important risk management strategy for me as an investor. Energy is a large part of the economy, so having at least some exposure to energy shares in my portfolio allows me to benefit from its performance. Instead of loss-making growth shares focussed on developing new energy, I prefer dividend paying oil and gas companies with substantial, well-developed assets – like Exxon.

Oil shares and political risk

Mounting environmental pressure has led to strategy changes at many European oil companies, which could lead to reallocating capital to alternative energy businesses with unproven potential. That is why I am now restricting my portfolio to US energy shares.

As I see scale as the name of the game, I choose large companies like Exxon. But they also face political risks, and the risk of falling energy prices.

So I limit my exposure and try to buy when oil prices are depressed, waiting for an upturn. Oil prices certainly aren’t depressed at the moment, so I’m not buying for my portfolio.

Christopher Ruane owns shares in Exxon. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.