2 Investment Lessons From Warren Buffett’s Massive Energy Bet

When Warren Buffett bets big on something, the finance industry takes note. To be honest, if Buffett does anything at all, the investment community watches intently.

And for good reason. His holding company, Berkshire Hathaway, has delivered an annual rate of return of about 20% dating back to 1965, which is double the rate of return from the S&P 500 over the same period.

This year, Buffett has bet big on energy, specifically oil companies. According to Berkshire Hathaway’s most recent 13F (an SEC-mandated form that institutional investment managers file on a quarterly basis), Buffett has invested over $25 billion in oil companies in the first quarter of 2022.

Here are two valuable investing lessons we can glean from this massive bet on the fossil fuel industry.

Image source: Getty Images.

Invest in stocks with secular tailwinds

The oil and gas industry has done exceptionally well in 2022, in a year when the overall market is down big. The reasons are pretty obvious. When lockdowns went into effect in 2020, people stopped driving and the demand for gasoline collapsed nearly overnight. This resulted in a significant reduction in drilling by oil companies. But more recently, as people began returning to work and venturing out of their homes after the lockdowns, demand for gasoline went through the roof.

Then Russia invaded Ukraine, which further squeezed the oil supply. In other words, demand has surged and supply has shrunk. You don’t need a Ph.D in economics to understand why oil prices have skyrocketed this year.

So, it makes perfect sense that Warren Buffett invested in oil companies recently, but is this really a “secular tailwind?”

According to U.S. Energy Information Administration forecasts, U.S. crude oil production will likely average 11.9 million barrels per day (B/D) in 2022, and 12.8 million B/D in 2023, which would set a record for most U.S. crude oil production in a single year.

While it might seem like we are on the brink of severing our dependence on fossil fuels, in reality we are setting new records for oil production. If these forecasts are accurate, it’s clear our society is not moving to renewables as our primary energy source anytime soon.

This is what Buffett is betting on, and so far, it’s paid off.

Invest in what you know

Buffett and Berkshire Hathaway have been investing in energy companies for many years, so it’s safe to say this is a sector they understand well. While the rest of the world seems to have written off the fossil fuel industry as an aging dinosaur, Buffett used his in-depth knowledge of the oil production process to his advantage.

In the first quarter of 2022, Buffett bought $7 billion worth of shares of Occidental Petroleum (NYSE: OXY) and increased his stake in Chevron (NYSE: CVX) by over $20 billion.

So far, those bets have paid off tremendously:

CVX Total Return Level data by YCharts

At first glance, you might think this investment is just a lucky short-term speculation on the price of oil. But if you dive deeper into the intricacies of the industry, you begin to see why Buffett has placed such a sizable bet on these two companies.

Two tables to understand the oil and gas industry

The fossil fuel industry is complex, but the two tables below could shed some light on Buffett’s strategy for investing heavily in this sector.

First, the oil and natural gas industry is divided into three streams: upstream, midstream, and downstream. Here’s a breakdown of each one’s role in the overall production process:

Upstream

Midstream

Downstream

Locating new oil fields

Storing crude oil and gas

Refining crude oil and natural gas into the finished product

Drilling wells/offshore rigs

Transporting oil and gas

Selling to distributors (gas stations, home gas providers, fertilizer producers, etc.)

Pumping crude oil out of the ground

Operating pipelines

Sometimes selling finished product directly to the consumer

Data source:

Some companies operate in a single stream, while others participate across the spectrum. These are known as “integrated” oil and gas companies.

While it’s understandable to think that any company operating in this industry would be heavily impacted by the rising or falling price of oil, this is not necessarily the case, and Buffett understands this.

The next table demonstrates how each stream is affected by oil prices.

How the Different Energy Streams Are Impacted by Oil Prices

Upstream

Midstream

Downstream

Most impacted

Less impacted

Least impacted

This is because…

The cost of extracting the crude product is extremely high and largely fixed, while the price they can sell it at fluctuates. If the price of oil drops, so do profit margins.

This is because…

These companies collect a fee for transporting crude oil, they don’t sell it. This means they are more insulated to price fluctuations; however, they are not immune. As prices fall, less oil is extracted and less of it needs to be transported.

This is because…

Since these companies refine the crude oil into usable products, they charge a premium, which gives them pricing power.

Data source:

Both Chevron and Occidental Petroleum are integrated oil companies, meaning they own and operate assets across all three streams of the production and refinery process.

So, while these companies have heavily benefited from the rise in oil prices, they are also insulated from price drops in the future.

Play to your strengths

The main takeaway from Buffett’s energy bet is to look to sectors and industries within your area of expertise because you’ll recognize unique opportunities. And when those sectors benefit from macro-economic tailwinds, you could be looking at a once-in-a-decade buying scenario.

As a long-term investor in the oil and gas industry, Buffett was able to see the writing on the wall and understand this is likely not a short-term boom for integrated oil companies like Chevron and Occidental Petroleum.

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Mark Blank has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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