How To Invest In Oil
- Real Vision
- November 29, 2021
- 2:39 AM
Oil investments may have once been dominated by the wealthy oil barons and moguls, but those times are long gone. There are now a multitude of options for the investor interested in this key commodity. Purchasing crude by the barrel is often not an option – but fear not – as there are now a host of indirect alternatives including oil futures, oil stocks, oil ETFs, and direct oil investments.
What is oil commonly used for?
Oil is a unique commodity that has, without a doubt, shaped the world we know today. You wouldn’t be sitting there reading this now without it, that’s for sure. Since its discovery in the 19th Century, it has become the backbone of many countries and nations worldwide. It is not by chance that it was given the nickname ‘black gold’.
The liquid that is extracted directly from the ground is called crude. Crude is then processed and utilized for a vast range of petroleum-based products. There will likely be several products in your home that oil was used in the production of.
While energy production is a key application, oil’s usefulness stretches far beyond generating power. There are far too many products to name here but examples include construction, clothing, medical devices, agricultural products, toys, office equipment, and not to forget any item containing plastic.
Different standards of oil
When dealing with crude, it is important to remember that not all oil is created equally. Oil is a natural resource that is extracted from different places around the world. As a result of varying geologic conditions, the quality of oil varies considerably.
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For example, North Sea oil contains a distinct composition in comparison to oil extracted from the Gulf of Mexico. Even within the Gulf of Mexico, there are different quality standards. This can make certain products more tradable and attractive. Although not directly affecting an investment position, it is important to understand this when performing a wider knowledge gathering.
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What to look out for when investing
Oil markets
The returns from many oil-related investment products are tied to the price per barrel. For investors, there are two main markets that are crucial to keep an eye on.
- WTI. For oil traded within North America, West Texas Intermediate (WTI) crude is used for pricing. This is traded through the New York Stock Exchange (NYSE).
- Brent. For oil traded throughout Europe, Africa, and the Middle East, North Sea Brent crude, or Brent for short, is used for pricing. This is traded through the Intercontinental Exchange (ICE).
Prices of these two oil markets are usually similar, but varying market conditions can mean they sometimes deviate by a few dollars.
OPEC
The Organization of the Petroleum Exporting Countries, or OPEC for short, is a collection of the largest 13 oil-exporting countries. It was created to manage the supply of oil and, therefore, attempt to set fair oil prices globally. Any decisions made by the group greatly impact the movements of WTI and Brent.
Although created for the largest exporters of oil in the world, some countries such as Russia, the USA, Qatar, and China are not members of the group. This leaves them free to set their own production levels. Thankfully, overproduction or underproduction is not profitable for any country in the long run but decisions made by these oil-exporting giants can still rapidly affect oil prices.
Is Oil a good investment?
Oil is key to so many products worldwide and will continue to be needed for the foreseeable future. It’s currently irreplaceable for many products, so while the world’s reliance on it is high, oil-related investment products remain relatively safe.
That being said, each product will hold its own risk characteristics. Investing in an oil ETF is not the same as buying oil futures, which usually requires a stronger stomach for risk in return for potentially higher rewards.
So is oil a good investment? Well, looking at some key pros and cons might help you to decide whether oil is the right investment choice for you.
Pros
- Oil can diversify an investment portfolio
- It is currently an irreplaceable commodity crucial for modern-day life
- Oil investments can offer tax advantages for US citizens
- Depending on the product chosen, it can provide a consistent flow of cash
Cons
- Oil prices can be heavily affected by geopolitical policies
- There can be rapid fluctuations in oil price
- The world is trying to decrease its reliance on oil
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What to invest in?
Gone are the days when the only option for investing in oil was to purchase crude directly. Crude oil is certainly still an option, but there are now 5 other ways an investment portfolio can gain exposure to the oil industry.
Crude oil
Spot contracts
An investment in physical crude oil is usually achieved via spot or futures contracts. While individual investors can invest in crude through spot contracts, it does involve the immediate delivery of physical oil. Realistically the average investor, ourselves included, doesn’t have a container ship waiting in the docks for storage. So, as a result, most like to stick with oil futures.
Futures contracts
Unlike spot contracts which allow investors to purchase oil at the current market price, futures contracts are an agreement between two parties to purchase a number of oil barrels at a predetermined price on a date in the future.
When buying or going long a futures contract, investors profit if the price of oil increases above the price purchased. And this is, of course, reversed when selling (aka going short).
Benefits
- When trading futures, investors are trading the contract itself, rather than the physical commodity. Buying and selling futures contracts provides the advantage that an investor can usually offload their futures contracts to others before needing to take delivery of physical oil.
- Many trading platforms offer futures with leverage. When traded profitably it can mean futures are extremely lucrative.
Risks
- Although trading futures can offer higher returns, on the flip side higher leverage can as easily result in much higher losses.
- Black swan events such as the April 2020 COVID-19 pandemic can wreak havoc in the futures markets. As the world turned off the taps and demand for fuel diminished, long oil futures investors could not find anyone to purchase contracts. Prices continued to fall to attract buyers. It continued until the price of oil futures went temporarily negative. Yep, traders actually had to pay people to take contracts off them. Pretty crazy stuff. This was a black swan event and is an extreme example, but it’s certainly a risk worth knowing about.
Oil stocks
A clear alternative to investing in crude oil is to invest in oil-related stocks. These oil stocks can be categorized into upstream, midstream, downstream, integrated, and service.
- Upstream. This sector of the industry is better known as exploration and production (E&P). Classified as upstream because these are the companies that find oil all around the world. By purchasing exploration rights, if oil is found they can make huge returns. Once found, they then extract it from the subsurface. However, it’s not all plain sailing. Often exploration rights are purchased without a discovery being made. As oil and gas form the monetary supply of the company, these stocks are heavily influenced by oil prices. Examples of upstream companies include Conoco Phillips and EOG Resources.
- Midstream. As the name suggests, midstream companies focus on the middle of the supply chain. This involves the transportation and storage of oil after discovery. They also transport refined products. Thanks to fixed contracts, midstream companies can avoid some oil price volatility. Midstream companies include Enbridge, Energy Transfer, and Enterprise Products Partners.
- Downstream. The last port of call for oil are those that either refine crude into more useful everyday products or sell oil-based products to consumers. Downstream stocks are heavily influenced by oil prices, as lower prices often mean lower demand for products. Marathon Petroleum, Valero, and Phillips 66 are a few examples.
- Integrated. These companies are the oil majors & supermajors of the world that combine several or all of the categories described above. The combined nature means integrated companies are greatly affected by oil price changes. Examples of supermajors include Exxon Mobil, Royal Dutch Shell, BP, and Chevron.
- Oil services. The oil industry stretches far beyond companies that actively explore or produce the stuff. There is a whole level of infrastructure behind the scenes that may provide a great proxy oil stock. They are not involved directly in any aspect of oil supply but could manufacture parts for wells, collect geophysical data or provide transportation services. Service companies usually expand outside of the oil industry, therefore, can often shelter from oil price movements. Examples include Schlumberger, Haliburton, and Baker Hughes.
Benefits
- Dividends are paid by many ‘blue chip’ oil stocks. These quarterly or bi-annual payments can be reinvested to increase the growth of a portfolio. Over the last year, both Exxon Mobil and Chevron have offered a dividend yield of over 5%.
- Depending on monetary streams some oil stocks can provide shelter from oil price volatility.
Risks
- Selecting one or two oil stocks can lead to a lack of diversification.
- Like any stock, a company’s financials will be crucial to lasting success. You’ll be investing in oil, yes, but if fundamentals are poor, oil price increases may not be enough. Remember to do your own research (DYOR) on individual companies.
Oil ETFs
A classic alternative for those not wanting to select individual oil stocks is to invest in an oil-focused exchange-traded fund (ETF).
ETFs are a collection of stocks that can be purchased all at once. They are usually offered by investment banks or financial institutions. An oil-focused ETF may be the optimum solution if you have an appetite specifically for oil and want to keep exposure as diversified as possible. By gaining exposure to a collection of upstream, midstream, and downstream stocks it can limit the risk of market downturns.
Benefits
- A quick and reliable way to diversify an oil investment. For example, the Vanguard Energy ETF holds 94 different stocks in the portfolio.
- Just like oil stocks, some ETFs pay dividends to investors. Although potentially not as high as individual stocks, dividends can provide quarterly or bi-annual cash flow.
Risks
- Selecting one or two oil stocks can lead to a lack of diversification.
- Like any stock, a company’s financials will be crucial to lasting success. You’ll be investing in oil, yes, but if fundamentals are poor, oil price increases may not be enough. Remember to do your own research (DYOR) on individual companies.
Direct oil investments
For those with some seriously deep pockets and looking for an investment option in oil that is a little outside the remit of ‘traditional’ avenues, investing in oil wells and oil licenses could make an enticing proposal.
When exploring for oil, land is usually dissected into smaller pieces of exploration acreage. The owner of each acreage holds the mineral rights to everything found. To encourage drilling and limit risk these rights can often be shared among investors in return for funding. If oil is found while drilling, any profits are then distributed amongst investors.
Similar to purchasing a share of land ownership, investors can also contribute towards drilling costs in return for a piece of the ‘black gold’ pie. Wells can be extremely expensive to drill and, therefore, often require external funding. Direct participation programs (DPPs) are common platforms for investors to join a group of like-minded people looking for drilling opportunities.
Benefits
- It is a high-risk but high-reward strategy. If completed diligently, profits could outpace other options in this list.
- Risk can be shared among members of a direct participation program.
- Direct investments in exploration and production can provide tax benefits.
Risks
- Usually requires a significant upfront investment.
- It could take several years for profits to materialize. Getting to the stage of drilling an exploration well usually takes longer than 5 years, and even then there is no guarantee of returns.
- Searching for the best opportunities usually requires having a hand in the game.
- With less focus on oil, drilling and exploration opportunities will likely become harder to find in the future.
Is there a right time to invest?
Yes. As a limited resource, oil is valued by supply and demand. It is often said when investing that time in the market is better than timing the market. This may have been true for crude oil before the crash of 2008, but over the last decade, oil has experienced a much more cyclical price pattern, ranging from highs of $120 to lows of $15.
When purchasing oil directly, those that waited for the next downturn in price will have profited much more than those buying the highs. The question you need to ask yourself is do you think oil prices are likely to drop lower? Or is there enough demand to keep oil prices climbing consistently from here on in?
And no. As there is no viable replacement for oil in the current world, prices usually maintain a consistent ‘floor’. Prices only fall so far before investors see an opportunity and start buying again. As governments place pressure on companies to find and utilize renewable energy solutions, less investment will find its way to oil. If the demand for oil persists and supplies dwindle, this oil price ‘floor’ may continue to rise.
Summary
Investing in oil can provide a great option for those looking to diversify an existing investment portfolio and there are now plenty of options to satisfy an oil appetite. Each of the methods described offers distinct advantages and disadvantages, which means it’s up to you to decide which best fits your portfolio.
Oil futures offer leverage for short-term positions and limit the risk of physical delivery. Oil stocks and ETFs provide a proxy investment with high dividend yields, and direct oil investments can yield a tax-saving high-risk high-reward strategy. Timing the market can be advantageous but is not necessary for every product and, if you can, remember to keep your finger on the geopolitical pulse.