Enquest (LSE: ENQ) is one of the markets most promising exploration and production oil companies. The companys shares could turn out to be a multi-bagger over time.
However, in the oil sector nothings 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.
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 isBP(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 companys 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 companys dividend payout is relatively safe for the time being.
On the other hand, as a plain vanilla E&P company, Enquests profits are highly sensitive to the price of oil.
For example, City analysts expect the companys earnings per share to drop by a staggering 87% this year as high production costs and the weak oil price squeeze margins.BPs 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, theres no reason why the companys earnings cant return to their 2014 high as well.
Moreover, if Enquestsvaluation were to return to its historic average of 12 times earnings, on earnings per share of 11.3p, the companys 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.
Thats why a basket approach is your best bet.
Risk reward
A 1,000 basket split equally between BP and Enquestwould yield around 2.7% per year.
If Enquestsshares returned to 136p, the value of the Enquest holding would rise to 1,214 and the portfolios overall value would rise by 72%.Of course, theres 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, theres a chance you could lose everything.
The best way
A basket approach is the best way to profit from high-risk companies without losing your shirt. And BP isn’t the only company out there that would make a greatincome ‘backbone’ for your basket portfolio.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.