Enquest (LSE: ENQ) is one of the market’s most promising exploration and production oil companies. The company’s shares could turn out to be a multi-bagger over time.
However, in the oil sector nothing’s certain, and, as a relatively small oil company, Enquest is still a risky pick.
A basket approach
The best way to reduce risk when investing in small-cap oil cos like Enquest is to use a basket approach.
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Simply put, a basket approach combines high-risk growth stocks, with low-risk, large-cap income stocks. This approach gives your portfolio a degree of stability and a regular income while also allowing you to benefit from capital growth.
And the best company to accompany Enquest in a basket portfolio is BP (LSE: BP)
Income champion
BP is an income champion and currently supports a dividend yield of 5.5%. The payout is set to increase by around 5% next year, which should give the company’s shares a yield of 5.7%.
Unlike Enquest, BP is an integrated oil company and can profit when the price of oil is both rising and falling. On that basis, the company’s dividend payout is relatively safe for the time being.
On the other hand, as a plain vanilla E&P company, Enquest’s profits are highly sensitive to the price of oil.
For example, City analysts expect the company’s earnings per share to drop by a staggering 87% this year as high production costs and the weak oil price squeeze margins. BP’s earnings are expected to rise by around 80% this year.
Multi-bagger
Last year Enquest reported earnings per share of 11.3p. If the price of oil returns to its 2014 high of $110, there’s no reason why the company’s earnings can’t return to their 2014 high as well.
Moreover, if Enquest’s valuation were to return to its historic average of 12 times earnings, on earnings per share of 11.3p, the company’s shares could be worth 136p — 142% above current levels.
But this is only a hypothetical situation, and no one can be sure when the price of oil will return to its 2014 high.
That’s why a basket approach is your best bet.
Risk reward
A £1,000 basket split equally between BP and Enquest would yield around 2.7% per year.
If Enquest’s shares returned to 136p, the value of the Enquest holding would rise to £1,214 and the portfolio’s overall value would rise by 72%. Of course, there’s also the potential for capital growth with BP as well.
The most important thing to remember with a basket approach is that it limits your downside. If Enquest does go under, the basket portfolio will lose around 50% of its value, which is a big hit.
Nevertheless, the remaining BP holding will continue to produce income, and over time, you will be able to recoup your losses. Without using the basket approach, there’s a chance you could lose everything.
