Crude oil is perhaps the most vital natural resource for the world economy. This raw commodity is refined to make gasoline, jet fuel and a host of other products. Price changes in the global market for crude oil are closely followed by investors everywhere.
What Is Crude Oil?
Crude oil is an unrefined type of petroleum. As a non-renewable fossil fuel, the total supply of crude oil is limited and can’t be replaced once exhausted.
Found below the earth’s surface, nearly half the supply is produced in the U.S., Saudi Arabia and Russia. Historically, crude oil has been obtained primarily via drilling into underground or underwater reservoirs, though fracking—injecting high-pressured liquid into underground reservoirs—is a newer technique.
Once extracted, crude oil is refined and processed into a variety of products, including gasoline, diesel, jet fuel, heating oil, kerosene, asphalt and lubricants.
These end products are then purchased by consumers, businesses and governments around the world for transporting people and goods and heating homes and buildings, among a very wide range of uses.
Crude Oil Prices
As with any market, the supply of crude oil and demand for its refined products dictates the price of this commodity.
With oil, the main driver of prices is inventory—or rather the perception of inventory, says Peter McNally, the global sector lead for industrials, materials and energy at Third Bridge Group Limited. “As inventories go down, prices go up.”
That said, fluctuations in demand can also cause swings in oil prices. The sharp decline in demand for crude oil products amid lockdowns at the outset of the Covid-19 pandemic also affected oil prices, even causing the price of oil futures contracts to turn briefly negative for the first time in history.
The futures market is the primary market for trading crude oil, and one futures contract represents 1,000 barrels. As with other commodities that trade in the futures market, there are contracts for different months that dictate delivery. The price of oil refers to the price of one barrel and refers to the most active futures contract, which is the nearest month for delivery.
There are two primary futures markets for crude oil—West Texas Intermediate (WTI), which is the benchmark for the North American market, and Brent, which is the benchmark for the rest of the world. While the two markets generally move together directionally, prices will often vary depending on geographic factors.
How Can You Trade Crude Oil?
The futures market is the most direct way to trade crude oil, but it’s not practical for most investors.
As is the case with all derivatives—investment contracts that derive their value from an underlying asset—brokers will require futures traders to pay a “margin” up front, or a certain percentage of the value of the trade. What’s more, traders who don’t close their position in a crude oil futures contract must be prepared for physical delivery of the barrels—and not only is that wildly impractical for most people, some brokers don’t allow for physical delivery.
“Trading crude can be risky business due to the volatile nature of oil prices,” notes Alec Quaid, a certified financial planner at American Portfolios. “Not only do you have to understand the fundamentals, but you need to be proficient in technical analysis, as well.”
Luckily there are plenty of better ways for oil-minded traders to gain exposure to the energy market, Quaid notes. He recommends two strategies: Buy individual stocks of oil-related companies or invest in exchange-traded funds (ETFs) that track the oil industry.
Investing in companies that will benefit from changes in oil prices provides an easier and safer way for most people to invest in oil—and will often pay investors in the form of dividends, as well.
Risks of Investing in Crude Oil
Beyond the risks associated with trading futures in general, investing in crude oil presents some other risks:
Because oil is so vital to the functioning of the world economy, its price is also sensitive to changes in the pace of global economic growth. The consumption of crude oil end products like gasoline can fluctuate, insomuch as that demand is discretionary.
As a result, if there’s an economic slowdown or a recession in a major oil-consuming country, region or much of the world, that will likely be accompanied by a big decline in oil prices.
Conflict and political problems are taking place in many of the countries most involved in the crude oil economy. These geopolitical issues affect supply and demand—and oil prices, as a result.
For example, negotiations within OPEC—the Organization of the Petroleum Exporting Countries—are necessary to monitor, and can quickly change dynamics within the oil market, Quaid notes.
Dynamics within the major oil-producing countries can have a ripple effect on the supply of oil that’s available globally. Russia’s 2022 invasion of Ukraine is just one example because sanctions against Russia resulted in a spike in the price of oil.
“You’re investing in something that’s really sensitive to things going on geopolitically,” McNally notes. At times, traders could find themselves almost feeling like you’re rooting for disruptions that will boost the price of crude, he adds.
The Dynamics of Oil-Related Markets
There’s a steep learning curve associated with trading crude oil in the futures market, and that’s not necessarily made entirely simple by opting to gain exposure to the commodity within the equity market. Production-related issues that are beneficial to the price of crude oil, for example, aren’t necessarily good for a specific company that’s directly affected, McNally notes.
Benefits of Investing in Crude Oil
Investing in crude oil offers concrete benefits. Here’s what you need to know:
To minimize risks in your broader portfolio, it’s smart to focus on diversification and invest in a variety of different assets that don’t all move in lockstep. Adding exposure to crude oil, or energy stocks more broadly, could help balance your portfolio when oil prices are rising and stock prices are falling—or vice versa.
Because the oil industry was “shunned” by average investors for the better part of a decade, they missed out during periods of rising oil prices, McNally says.
Investors who opt to gain exposure to crude oil by investing in the stock market—either via individual stocks or ETFs—may realize another benefit: Dividends.
Companies in the energy sector are paying dividends that are growing faster than any other part of the U.S. stock market, according to Morningstar, and average dividend payments for these companies has increased by more than 50% since 2018.
Investors get exposure to the crude oil market, when prices rise, but are paid in the interim.
During periods when oil prices are surging, many investors may be tempted to branch out to a new type of asset to try and harvest some of those gains. While this certainly is tempting, the reality is that trading crude oil futures probably doesn’t factor into the amount of time and effort many average investors want to devote to the market.
Here’s the truth: The oil market is dominated by professional traders who spend their entire days wholly dedicated to trying to predict short-term fluctuations in both the supply of and demand for crude oil and its byproducts.
In fact, trading crude oil isn’t something Quaid says he and his colleagues actively do for clients. Rather, he recommends that his clients get exposure to the energy industry via ETFs.
Finally, McNally notes, investors should be prepared for some lack of predictability with this market. “This is a very cyclical industry,” he says.