Oil is one of the world’s most valuable resources, being the main source of energy for transportation and electricity production. Investing in oil can be an attractive option for those looking to diversify their investment portfolio, but it is important to understand the factors that influence the price of oil and how the oil market works.
In this article, we will explore the various investment options available to those who want to start investing in oil, the risks associated with such investments, and the important considerations to keep in mind when deciding to invest in this energy resource.
Investing in the oil industry: how it works
It is not uncommon for investors to be confused by the jargon used in this industry. It is extremely important to understand the process of extracting, refining, and trading this commodity, or its production chain, which can be technically divided into three segments:
- Upstream: Upstream companies are involved in the exploration and production of oil and gas. Upstream companies search for raw material reserves and extract them. They are mainly involved in the initial stages of production, such as drilling and extracting oil and gas. This segment is typically characterised by high capital investment, long duration, high risks, and intensive use of technology.
- Midstream: These companies mainly focus on everything that is necessary to transport and store crude oil for processing in refineries. Midstream activities are typically characterised by road transportation, shipping, raw material storage, and pipelines. They are also characterised by low capital risk and high regulation. They are heavily dependent on upstream companies.
- Downstream: Finally, downstream companies are the famous refineries, companies responsible for refining oil and gas into final products, from aircraft fuel to gasoline, synthetic rubber, containers, preservatives, and plastics.
What is the difference between Brent, WTI, and other types of oil-based assets?
Let’s delve into the two primary types of oil that exist. The main difference between Brent and WTI is the origin or the place of extraction. Brent originates in Europe and is a global benchmark that trades on London’s ICE Futures exchange; the index tracks the oil produced in Europe, Africa, and the Middle East. On the other hand, WTI is sourced from the US.
WTI is often deemed more valuable than Brent due to its lower sulfur content and higher API gravity (which measures density relative to water). Additionally, the price of WTI tends to be lower than Brent’s, despite transport costs. This is attributed to WTI’s higher production levels through techniques such as fracking, which has contributed to its competitive pricing advantage.
Check this Brent vs WTI article for a more detailed explanation.
Numerous factors continue to influence oil prices, ranging from macroeconomics and geopolitics to central bank policies, storage levels, demand and supply dynamics, decisions of OPEC Plus, the value of the dollar, and market sentiment. Despite the global oil market’s relative calm following the Ukraine-Russia conflict, oil prices have rebounded to pre-war levels. The International Energy Agency (IEA) anticipated a slowdown in global oil production for 2023 compared to the previous year.
China’s expanding fuel demand and new refinery operations are expected to drive record oil imports, especially as China and India step up as significant purchasers of Russian crude. Though central banks, stocks, and the dollar currently exert bearish pressure on prices, the announcement of the United States releasing 26 million barrels of crude from strategic reserves has added to downward market pressures. Nevertheless, looming oil supply shortages could potentially push prices toward $100 a barrel by year-end.
OPEC’s recent report highlights a slight increase in global oil demand growth for 2023. While world oil supply is projected to exceed demand in the first half of 2023, a potential deficit could arise as demand recuperates. The OPEC+ policy, which extends production cuts of 2 million barrels per day until the end of 2023, remains a significant factor in shaping the oil market’s trajectory.
Amid these dynamics, Russia’s decision to cut oil production by 500,000 barrels per day in response to Western price limitations on Russian oil and petroleum products plays a pivotal role. Notably, Russia’s main crude export, Ural, is being sold below $60 a barrel, aiming to attract new Asian buyers. This price positioning underscores the evolving landscape of the oil market.
How to invest in oil?
Below, we’ll explain how you can invest in oil.
How to invest in oil: shares of companies
One of the possibilities that the market offers to invest in such a particular sector as oil is certainly represented by the shares of listed companies. There are many oil companies dedicated to exploration, production, refining, sale of petroleum products, services and transportation.
Some of these stocks may increase and decrease according to the price fluctuations of crude oil. For example, the refining industry is based on crude oil as an input to produce gasoline, diesel, and other refined products. If crude oil prices rise without a corresponding increase in the price of refined energy products, investors can expect a drop in refinery stocks, as their profits decrease.
There are many oil stocks, including Eni, Aramco, Exxon Mobil, ConocoPhillips, British Petroleum, Chevron, Royal Dutch Shell, Repsol, PetroChina, and Petrobras. The best commission-free brokers offer a wide range of oil stocks to choose from.
Here are the top 3 oil companies with increasing performance last year:
Exxon Mobil Corporation:
Invest in oil with ETFs
The other tool that the market offers to invest in oil is represented by ETFs. Exchange Traded Funds are investment funds listed on exchanges. There are certain differences between ETFs and index funds – have a look at index funds vs ETFs to understand each product.
The main difference is that most ETFs are passively managed. On the market, there is a wide variety of ETFs related to commodities that follow a wide variety of strategies.
Exchange-traded funds often replicate indices related to the price of commodities or represent baskets of securities linked to the commodities market. One of the main benefits is diversification – with only one trade, you invest in the entire basket of assets, and the best ETF brokers allow you to choose the right funds for your investing strategy..
This is a top 3 of oil ETFs and funds.
- Lyxor Stoxx EU600 Oil & Gas ETF: one-year return 23.18% (a fund that follows the rise and fall of the performance of large European companies in the oil and gas sector)
- iShares U.S Oil & Gas Exploration & Production ETF: 17.21% (an ETF that seeks to replicate as faithfully as possible the performance of the S&P Commodity Producers Oil & Gas Exploration & Production index).
- WisdomTree Brent Crude Oil. The fund invests in the oil sector replicating the Bloomberg Brent Crude Sub Excess Return index. For example, if the Bloomberg Brent Crude Sub Total Return rises 1% in one day, then the ETC rises by 1% as well.
Invest in oil with derivatives: CFD, futures, options
Also, you can trade oil via derivatives. CFDs are the most popular options, but futures and options are also used by many savvy investors and traders to make profits or for hedging.
Trading oil with CFDs
CFDs are types of derivative contracts based on the price of the underlying assets. In other words, the CFD tracks the price of the asset, and you don’t own the underlying assets. Hence, the trader speculates on the increase or decrease in prices in order to obtain a profit.
Essentially, the CFD is a contract in which two parties agree to exchange money based on the change in value of an asset. In addition, CFDs are very easy to trade and available via most online brokers – have a look at the best brokers for CFDs.
A simple example of CFD trading on raw materials can be represented by the hypothesis of wanting to open a position on oil and then deciding whether to go long or short. Let’s assume going long as we are convinced that the price of crude will rise. Once the position is opened, we could make a profit or a loss depending on the movement of the oil price.
Trading with oil futures
Futures trading is one of the ways to invest in commodities, allowing the producer and the buyer to agree on a price and terms for the delivery of a commodity at a predetermined future date.
The future is a forward contract that sets the price of a commodity or a basket at the time of the contract that will be delivered at a future date. It is a legal agreement between two parties to trade an asset at a predetermined price at a specific future date.
The operator who buys the future (who commits to buying the underlying asset at maturity) takes a long position (long), while the operator who sells the future takes a short position.
Oil futures contracts are sized at 1,000 barrels. The financial markets where oil is traded are the Chicago Mercantile Exchange, the New York Mercantile Exchange, and the London Intercontinental Exchange, not to mention other important markets such as Tokyo, Shanghai, and Mumbai. The expiration of the contracts, as can be seen from the following table, is monthly.
In simplified terms, a contract for 1,000 barrels at $50 per barrel is agreed upon between two people and expires on X. Two cases can be verified:
- The barrel price drops before expiration. If, for example, the price were to drop to $49 per barrel, you would lose $1,000 (1 dollar x 1,000 barrels).
- The barrel price increases before expiration. If, for example, the price were to rise to $51 per barrel, you would gain $1,000 (1 dollar x 1,000 barrels).
Trading oil with options
Options trading means entering into contracts that give the buyer the right to buy or sell a commodity at a predetermined price at a certain expiration date. This is another way to invest in commodities. The use of options can also be used to protect an investment as in the case of a negative performance with the option it is possible to exercise the right to sell at a predetermined price.
For a call option, the buyer has the right but not the obligation to buy an underlying at a predetermined price, on a specific date. The seller has the obligation to sell the asset if the buyer exercises the right to buy.
In this case, the buyer has expectations of an upward trend in the future price of crude oil. A put option gives the buyer the right but not the obligation to sell at a predetermined price, on a specific date. The seller has the obligation to buy if the option buyer decides to exercise the right to sell.
Check out the best brokers for options.
What factors influence oil price?
Let’s try to understand the factors that move the price of this commodity.
The price of oil, like that of other goods, depends on the demand and the supply of oil.
- On the demand side, consumers and households influence the price of oil. The higher the demand, the higher the price climbs if the supply remains unchanged.
- On the supply side, contrary to what many think, the largest producer of oil is the United States and not Saudi Arabia. The reason is due to the discovery of fracking of “bituminous shales” in Texas and North Dakota and to the reduction of Saudi Arabia’s production due to the continuous attacks on its deposits.
It’s worth clarifying the difference between oil production and oil reserves – oil reserves refer to oil not extracted yet. In this sense, the United States, with 36.5 billion barrels of reserves, are far behind other oil-producing countries such as Venezuela (266 billion barrels), Iran (158 billion), Iraq (143 billion) and Kuwait (102 billion). Russia and Saudi Arabia have 98 and 80 billion respectively. This information is important to determine the future supply capacity and the flows of imports and exports.
However, the Organisation of the Petroleum Exporting Countries (OPEC), founded in the 1960s and mainly composed of Saudi Arabia, Kuwait, Iran, Iraq and Venezuela, plays a fundamental role on the oil supply front. Even if the organisation’s statute does not explicitly say so, they are the ones who set the prices on the market. If OPEC decides to limit production, it can raise oil prices.
Investing in “black gold” means taking on a high level of risk, fundamentally because some of the producing countries are areas of war and political conflict, so fluctuations can be considerable.
Other current issues
Before continuing with oil, we often hear about alternative sources, renewable energies necessary to reduce emissions and all the consequences of using fossil fuels.
- Carbon emissions: Governments are trying to respond to the challenge through programs aimed at sustainability and efficiency. There is still a long way to go. The Italian framework, for example, remains rich in potential but scant in achieved successes. Solar, wind, geothermal, and biomass, there are many low-impact environmental sources. Renewable energies can be traced back to natural sources that are not subject to exhaustion. A world without oil is possible but the path is really long and full of obstacles.
- The other factor that undoubtedly influences the fluctuations in crude oil prices is related to storage levels. These data are communicated weekly by the American Petroleum Institute and the Energy Information Administration. In recent months, crude oil stocks in the United States have increased significantly. This weighs on prices. Essentially, they have increased by almost 24 million barrels in the last two weeks, adding to an already oversupplied market.
- The Iranian issue: there is currently no definitive agreement to lift US restrictions on Iranian oil. The European Union also does not hide the enormous difficulties in carrying out the already complicated negotiations between the countries of the agreement.
Historical oil prices
Without necessarily looking too much into past, oil prices have suffered with sudden oscillations and increases in volatility. The oil market is known for its high risks and volatility.
Geopolitical risks, demand and supply, and sudden events (such as shortages or attacks) can heavily impact the prices of oil. For example, think about the drone attack on Saudi Aramco’s oil facilities, an attack claimed by a military spokesman for a Yemeni armed group. But this is not the first time such a situation has occurred and when such events occur, there is always an immediate surge in prices.
Alternatives to investing in oil
- Investing in commodities
- Investing in metals
- Investing in precious metals
- Investing in silver
- Investing in water
Investing in oil: summary
In conclusion, investing in oil involves navigating a dynamic landscape influenced by factors such as global politics, technology, and demand trends. The choices between benchmarks like Brent and WTI, the impact of policies set by entities like OPEC+, and the rise of markets like China highlight the complexity of oil investment. Success in this field requires a clear understanding of market forces and a strategic approach to capitalise on opportunities. As the energy industry continues to evolve, those who invest in oil must stay informed, adaptable, and attuned to the global shifts that shape this essential sector.
Why should I consider investing in oil?
Investing in oil offers exposure to a fundamental global commodity that plays a vital role in various industries. Oil is essential for energy production, transportation, manufacturing, and more. It can serve as a diversification tool in a well-balanced investment portfolio.
How does the price of oil affect my investment?
The price of oil directly influences the profitability of oil-related investments. When oil prices rise, companies in the industry may see increased revenues and profits. Conversely, when oil prices fall, these companies might face challenges. Understanding market trends and global factors that impact oil prices is crucial.
What are the risks associated with investing in oil?
Investing in oil involves risks like any investment. Oil prices can be volatile due to geopolitical tensions, supply-demand imbalances, and economic fluctuations. Regulatory changes, technological advancements, and environmental concerns can also impact the industry. It’s important to be prepared for these uncertainties.