Oil as an Asset and an Investment
Oil is the world’s most heavily traded commodity. As an asset, it is crucial to almost every aspect of economic production, from powering transportation to being an input in manufacturing, to powering the electric grid. It is attractive as an investment because consumers of the commodity cannot quickly adapt to changes in supply, and price volatility presents profit opportunities for traders.
Many investors hold positions in oil as a commodity, in companies that engage in drilling, production and refining, or in derivatives that track the oil industry. Investment in oil and oil companies offer profit from price fluctuations and generous dividends, but the volatility of the commodity and the cyclic nature of the industry mean that it isn’t for the fair-weather investor.
If you are looking to profit from oil, you have many options to consider. If you want to invest in the commodity, you can consider futures, options, commodity ETFs and ETNs. If you’re interested in exposure to the production and distribution of oil, you can choose from a variety of stocks, mutual funds and ETFs.
How to Invest in Oil
Futures and Options
Two of the most popular ways to invest in oil as a commodity, and the one with perhaps the most upside (and downside) potential are futures and options contracts.
When you buy a futures contract, you are committing to buy or sell a specific asset at a future date, at a set price. Futures contracts for oil are sold with monthly delivery dates, so if you are purchasing futures in oil, you might buy a contract on West Texas Intermediate (WTI) crude oil for delivery in July oil next year. Futures contracts require you to have a brokerage account that is approved to trade futures, which requires more scrutiny than a standard stock brokerage account. Futures are bought on margin, meaning that you only need to provide a portion of the contract value in cash to your broker.
Because most futures traders do not actually want to take delivery or oil or have a warehouse of barrels of oil to sell, most futures contracts that are held until expiration will be settled in cash. If you hold a futures contract on the last day of trading, the futures contract will usually be marked to market and your trading account will be debited or credited, depending on whether your contract is sold at a profit or loss. Some traders roll futures positions into new longer-term contracts in order to maintain their positions.
Another way to speculate on the future price of oil is through options contracts. An option is a contract that grants you the right to buy or sell a commodity at a contracted price for a specific period of time. Options can be purchased as calls or puts. A call gives you the option to buy an underlying asset at a specific price before the expiration date. Conversely, a put gives you the option to sell an underlying asset before the expiration date.
If you purchase a call option on West Texas Intermediate Crude (WTI) at $100 and the price rises to $120 before your option expires, you can exercise the option for a profit of $20. If the price of WTI drops to $80 prior to exercising your option, your option becomes worthless.
Commodity ETFs and ETNs
For investors who want to speculate on the cost of oil, two options that do not carry the expense of risk of options and futures contracts are commodity ETFs and ETNs.
An ETF, or exchange-traded fund, is a security similar to a mutual fund that seeks a particular investment objective. Like a mutual fund, the ETF will own a pool of underlying assets, but unlike a mutual fund, ETFs can be traded on stock exchanges, the same way that a regular stock can, making them more liquid and cost-effective than most similar mutual funds. ETFs can either be passively or actively managed. A passively-managed ETF might seek to track the performance of an index, whereas an actively-managed ETF would have a fund manager that selects investments to match the fund’s investment objectives.
ETFs can be a good choice for investing in oil as a commodity, as they are both liquid and do not require a margin account with a brokerage house. Several ETFs are available that track the price of oil.
Similar to an ETF, an exchange-traded note (ETN) can allow you speculate on the price of oil. An ETN is a type of bond, an unsecured debt security typically offered by a financial institution, that tracks an underlying index. Upon maturity an ETN will pay the return of the index that it tracks.
Unlike an ETF, an ETN does not provide underlying ownership of securities; it is simply a debt obligation of the issuing institution. ETNs carry the risk of the creditworthiness and solvency of the issuing institution. If the issuer’s credit rating receives a downgrade, the value of an ETN can decline, even if there is no change in the underlying commodity index. In the worst case, if an issuer of an ETN is unable to pay the principal of the ETN at maturity, they may default on the bond.
Energy Companies, Equity ETFs and Mutual Funds
If you want exposure to oil, but investing in commodities doesn’t match your investment strategy or risk tolerance, consider investing in companies that are involved in the drilling, production or distribution of oil and petroleum products.
One option is to directly buy shares of companies involved in oil extraction and production. These are companies like Exxon Mobil, BP, and PetroChina. However, if you are looking for performance that tracks the oil sector, investment in a specific energy company may not be your best bet. Fluctuations in stock prices of individual companies will be affected not only by industry factors, but also by the company’s specific investments and business activities.
If you are looking for a broad investment in the oil sector, you might want to consider one of the many equity ETFs or mutual funds that invests in oil companies.
For many investors, ETFs will be a better option than mutual funds. The advantages of ETFs include that they can be purchased and sold on a stock exchange, do not require a minimum level of investment and are generally more tax efficient than similar mutual funds. The costs associated with ETFs include their expense ratios and the costs of buying and selling, like brokerage fees and bid/ask spreads.
If you are looking to make periodic investments in the oil and gas industry, you might want to consider mutual funds. Mutual funds allow purchases in dollar amounts or fractional shares, so they can be a good choice if you employ a dollar-cost averaging strategy. Additionally, many mutual funds offer different classes of funds that have lower fees to investors who are able to invest a substantial amount of money in a single fund. If you consider mutual funds, be sure to understand both the operating expenses and fees unique to mutual funds, such as sales loads and early redemption fees.
When Should You Invest in Oil
When you should invest in oil depends on your investment objective. The oil and gas sector tends to be highly cyclical and volatile, meaning that you are likely to experience periods of prolonged high prices, prolonged low prices and price fluctuations. How your investment in oil matches your objectives will determine when you should invest in oil.
If you are looking to speculate on the movement of oil prices, the best time for you to invest in oil is prior to a large movement in oil prices. Of course, predicting the future movements of commodity prices is notoriously hard. Investors who speculate on future price movements generally base their analysis on information gleaned from leading indicators of increased demand or coming reductions in supply. Most investors would do well to stay away from speculative bets on the price of oil.
You might see the sector’s relatively high level of dividends as a reason to incorporate the oil and gas industry as part of a long-term investment strategy. If this is your objective, your best bet is to spread your investments out over some period of time or to make continuous periodic investments. Consider making periodic investments in oil investments using dollar-cost averaging. Employing a dollar-cost average strategy will give you the best chance of reducing variability from market timing.
Oil Investing Pro and Cons
Oil as a commodity and an industry has several unique aspects that may make it attractive or unattractive as part of your investment portfolio. Here are some of the biggest reasons why you might want to consider investing in, or shy away from investing in oil.
Oil is Cyclical
Depending on your investment strategy, this could be either a reason to invest in oil or a reason to stay away. If you are looking to profit from price fluctuations, the tendency of oil prices to cycle up and down with the business cycle can provide opportunities for profit. However, if you want consistent returns and the ability to exit the market at any time, the cyclical nature of oil would make it unattractive.
Oil and gas exploration is rife with uncertainty. When an oil company buys the rights to explore and drill for oil, there is no certainty that this investment will pay off because the expected oil reserves simply may not exist.
Some investors prefer that their investments match their values and these investors may be concerned about the externalities associated with oil exploration, production and consumption.
Oil drilling and production is not without risk. Mistakes that lead to natural disasters can have long-ranging impacts on an oil company.
Investors looking for attractive dividends may consider oil for the sector’s generally high dividends when prices are high, as oil companies tend to generate a substantial amount of cash during periods of high prices. Investors looking for consistent dividends may shy away from investments in oil companies, as the generous dividends tend to wane during periods of low prices.
Relatively Inelastic Demand
Globally, the demand for oil is relatively inelastic. As supplies tighten, consumers of oil are usually only able to marginally reduce their consumption in the short term, causing prices to shoot up with any disruption in supply.
How can I invest in oil with little money?
You can invest in oil with very little money. Many oil stocks trade for under $100 a share and there are several oil ETFs that trade for less than $100.
What is the best oil ETF?
There is no one best oil or energy ETF. When selecting an oil ETF, consider the ETF’s investment objective, whether it is actively or passively managed, and expenses.