When we talk about investing in commodities, without a doubt oil is one of the most traded in the world despite the fluctuations in its price. If you want to invest in oil, there are some things you should know.
In this post, we will provide you with an overview of how to invest in oil through different instruments, as well as the risks and benefits associated with this investment.
How does the oil industry work?
It is normal for investors to feel confused by the jargon used when valuing oil-related operations. We believe it is extremely important to understand the process of extracting, refining, and trading this commodity, that is, its production chain, which using technical terms can be divided into three segments:
The upstream companies have to do with the exploration and production of oil and gas. Upstream companies look for raw material reserves and extract them. They are mainly responsible for the initial stages of production, such as drilling and bringing oil and gas to the surface.
This segment is typically characterized by high capital investment, a prolonged duration, high risks, and intensive use of technology.
It is the process of the chain that is mainly focused on everything that is required to transport and store the crude for its processing in the refineries.
Midstream businesses are typically characterized by road transport, shipping, and storage of raw materials, and pipelines. They are also characterized by low capital risk and high regulation.
They are very dependent on upstream companies.
Finally, the downstream companies are the famous refineries, companies responsible for refining oil and gas and turning them into final products, from aircraft fuel, asphalt, gasoline, etc., to synthetic rubber, containers, preservatives and plastics.
What affects the price of oil?
Now that we have an understanding of the oil production chain, we must also understand the factors that drive the price of this raw material.
The price of oil, like that of other goods, depends on its supply and demand.
On the demand side, it is quite simple, the consumers who use goods and services on a daily basis that are directly or indirectly related to this material.
On the supply side, contrary to what most people may think, the largest producer of oil is the United States and not Saudi Arabia. The reason is due to the discovery of fracking of the “shale bituminous” in Texas and North Dakota and the reduction of Saudi Arabia’s production due to constant attacks on its oil fields.
|Country||Daily production 2021 (in barrels)|
|Saudi Arabia||9.3 million|
As a curious fact, Spain mainly imports oil from Nigeria, Mexico, Libya, Kazakhstan, the United States, Saudi Arabia and Iraq.
A concept that I would like to clarify here is the difference between oil production and oil reserves, the second is the oil that has not yet been extracted.
In this sense, the US with 36.500 million barrels in reserve is positioned far behind other producing countries such as Venezuela (266.000 million barrels), Iran (158.000 million), Iraq (143.000 million), and Kuwait (102.000 million). Russia and Saudi Arabia have 98.000 million and 80.000 million respectively. This information is important to determine future supply capacity and import and export flows.
Now, the Organization of Petroleum Exporting Countries (OPEC), founded in the 60s, mainly composed of Saudi Arabia, Kuwait, Iran, Iraq, and Venezuela, play a fundamental role in the supply side of crude oil. Although the organization’s statute does not explicitly state, they set the prices in the market. If OPEC decides to restrict production, it can force an increase in oil prices.
Investing in “black gold” means assuming a high level of risk, basically because the producing countries are zones of war and political conflict, so fluctuations can be considerable.
What has happened this year with oil? Why are you seeing the price of gasoline go up?
The price of gasoline in many countries is mainly determined by the price of crude oil and the exchange rate of currencies (remember that oil is traded in dollars).
The price of oil rose to its highest level in seven years as a result of the Ukraine war. Brent crude reached a high of $129.49 a barrel on March 8, reaching its highest level since 2014.
The war, the volatility of the price of oil has accelerated the inflation we are experiencing now.
How to invest in oil?
Understanding the supply and demand, it is time to talk about how to trade in this raw material. In the following sections, we explain in depth how to invest in oil through 6 stock instruments.
Storing REAL barrels of oil
First, there is the option of buying and selling crude oil physically, but it is not recommended for the individual investor since he would have to look for a place to store it, with extreme care for its level of toxicity and others.
The oil futures allow you to benefit from the fluctuations in the price of the barrel. Oil futures are futures contracts in which buyers and sellers of oil coordinate and agree to deliver specific amounts of physical crude oil on a specified date in the future, hence its name.
There are several types of crude oil in the world, but the ones we hear most often and that serve as a reference are mainly Brent and WTI (World Texas Intermediate).
Crude is traded on the ICE and on the NYMEX, with delivery dates for the twelve months of the year. Each futures contract is made up of 1,000 barrels of crude and its tick or minimum quotation variation is 0.01 dollars per barrel, that is, 10 dollars per contract.
Through this contract, the products of this matter are assured the sale of their barrels and the buyers are assured of receiving the barrels at the current price agreed. However, there are also speculators who try to make money through this type of contract, trying to sell them before their expiration, confident that the price of crude will rise.
The simplified operation is as follows, between two people a contract of 1,000 barrels at 50 dollars per barrel with expiration in X is agreed. Then two cases can occur:
- That the price of the barrel falls before the expiration. If for example, the price fell to 49 dollars per barrel, then 1,000$ would be lost (1$ x 1,000 barrels).
- That the price of the barrel rises before the expiration. If for example, the price rose to 51 dollars per barrel, then 1,000$ would be gained (1$ x 1,000 barrels).
If you are interested in futures, you can take a look at the brokers that offer these products.
Both futures and CFDs (contracts for differences) are derivatives and offer the same benefits of leverage, but while the first has an expiration date, the second does not have it, so CFDs are more flexible in this sense. In the future, due to the expiration date, there may be insufficient liquidity to unwind the position at an acceptable cost.
Due to the structure of financing costs, commissions, and opening rates, CFDs are better suited to small positions and short term, while futures are a better option for larger positions and longer term.
If you are interested in CFDs, you can take a look at the brokers that offer these products.
You can also invest in oil through ETFs. It is important to understand how they work because in some cases, they do not work as expected. Because ETFs rarely take physical possession of oil, the fund’s performance will depend on the expiration of futures contracts.
The main problem with this strategy is that the current month’s futures contracts tend to be lower than the contracts for future months. The result is that the fund usually suffers small losses every month due to the reinvestment process, and over time, those losses can accumulate into large drops, even when oil prices are steady or rising.
ETFs being based on derivative contracts traded on futures markets, are based on the convergence between the future value and the expected one. Here come into play the concepts of ‘Contango‘ and of ‘Backwardation‘. ‘Contango’ is considered when the price of the next future is higher than the current one and ‘backwardation’, is the opposite.
Below I show some examples of ETFs that can be contracted from Europe:
|ETF||Ticker||TER||Assets (in millions of €)|
|Invesco European Oil & Gas Sector UCITS ETF||SC0V||0.20%||14|
|Lyxor STOXX Europe 600 Oil & Gas UCITs ETF||LOGS||0.30%||479|
|iShares STOXX Europe 600 Oil & Gas UCITS ETF||EXH1||0.46%||945|
|iShares Oil & Gas Exploration & Production UICTS ETF||IS0D||0.55%||466|
However, there are others very well-known such as:
|United States Oil Fund ETF||USO|
|United Stated Brent Oil Fund ETF||BNO|
|WTI Crude Oil Fund ETF||CRUD|
You have the explanation of each ETF and some more examples in this article: What ETF of oil is better?
Shares of oil companies
You also have the option to invest through companies that explore, produce, transport, refine, and sell crude oil. Some of these companies, such as exploration and production companies, tend to increase in value when crude oil rises and decrease when crude oil falls.
For example, the refining industry depends on crude oil as an input to produce gasoline, diesel, and other refined energy products. If crude oil prices rise without a corresponding increase in the price of refined energy products, then investors can expect refinery stocks to fall, as their profits decrease.
|International Petroleum Corp||IPCO|
Perhaps in the current situation, it would be convenient to study the incorporation of tankers in our portfolio such as Golar (GLNG), Teekay (TK), and Euronav (EURN), among others.
Investment funds do not invest directly in oil but in companies in the production chain. These companies have a very high correlation with the value of oil but will never replicate its behavior. Generally, these are investment funds that invest in the energy sector in general. Here are some examples:
|Funds||ISIN||Where to hire|
|Goldman Sachs North America Energy & Energy Infrastructure Equity Portfolio R Acc EUR||LU1299707155||MyInvestor/EBN|
|BlackRock Global Funds – World Energy Fund A2||LU0122376428|
|NN (L) Energy – P Cap EUR||LU0332193696|
|Schroder ISF Global Energy A Accumulation||LU0374901568|
By the way, now that you know all the options when it comes to being exposed to crude oil, you may also be interested in knowing how to invest in gasoline, one of the most demanded refined products of oil in the world. You can enter by clicking on the link.
In short, you have many options when it comes to investing in oil, however, remember that it is a very traded market (one of the largest in the world), and therefore, you will face high doses of volatility and uncertainty.
How much does it cost to invest in oil?
The cost of investing in oil depends on the method you choose. Buying shares in an oil company is the same as buying any other stock, but buying oil futures or CFDs requires a margin deposit held by the broker. The margin requirement varies depending on the broker and the type of instrument you are trading.
What is the best way to invest in oil?
If you are looking for high returns, you may want to consider buying oil futures or CFDs. However, these instruments are more risky than buying shares in an oil company. If you are looking for a more conservative investment, you may want to consider buying shares in an oil company.