Basics of Oil & Oil Investing
Also known as crude oil or petroleum, oil is a fossil fuel formed from the remains of animals and plants living millions of years ago. The yellowish-black liquid is extracted from reservoirs beneath the Earth’s surface. Oil is used as a commodity that is refined into other products, such as gasoline, heating oil and asphalt.
Since oil is a commodity, meaning that it is a base product or raw material used to make other products, it has value as an asset. Like many other commodities, such as gold or various agricultural products, oil can be traded as an investment derivative.
Oil’s abundance, proven usefulness, and global popularity are among the reasons that some investors believe that the commodity will be a valued asset for the foreseeable future. These are among the qualities that attract investors and traders to the commodity.
Investing in oil can be done by gaining direct or indirect exposure to the commodity. Investors can gain exposure to oil directly through oil futures, oil options, or commodity-based exchange-traded funds (OTC:ETFS). To invest in oil indirectly, investors can buy energy sector ETFs, energy sector mutual funds, or stock in individual oil companies.
Important: When investing in oil, investors rarely take ownership of the commodity itself. This differs from equity investing, where shares of stock represent ownership of the issuing company. For this reason, the process of investing in oil is often referred to as “gaining exposure” to oil.
Gaining Direct Exposure to Oil
Investors can gain direct exposure to oil through the purchase of futures or options contracts or by buying commodities-based ETFs or mutual funds. Futures and options can be complex and involve a high degree of risk, whereas ETFs and mutual funds are relatively simple and moderately risky.
- Oil futures: Requires a buyer to purchase an investment security, or sell an investment security, on a specified expiration date, unless the position is closed before expiration. When it comes to oil futures, investors rarely intend on taking ownership of the asset.
- Oil options: Provides the buying investor the right to buy (call option) or sell (put option) the underlying asset, in this case, oil.
- Commodities funds: Enables an investor to buy shares of an ETF or mutual fund that tracks the performance, less fees, of an underlying commodity index, such as a crude oil index.
The type of investors that typically invest directly in oil is those who are willing to take on the added risk associated with futures, options, and speculation. Oil and other commodities can also be used for diversification and hedging strategies.
Tip: Futures and options have a subtle difference. Futures contracts represent an obligation to buy or sell a security, whereas options contracts represent the right to buy or sell a security.
Investing in Oil Indirectly
Indirect investments in oil won’t directly track the price of oil as a commodity but will invest in stocks that may be affected by oil prices. To gain indirect exposure to oil, investors can:
- Buy shares of a mutual fund or oil ETF that invests in stocks of companies in the oil industry. Examples include oil and exploration funds and energy sector funds.
- Purchase stock in individual oil companies. There are three types of oil companies: upstream companies, which drill for oil; midstream companies, which operate pipelines for transporting crude oil; and downstream companies that refine and sell the end products.
The type of investors who prefer indirect exposure to oil are typically those who do not want the added risk of direct exposure to oil as a commodity. For example, an energy sector mutual fund or ETF is one way to gain broad exposure to oil and energy stocks with less sensitivity to oil price fluctuations as direct oil investments.
Pros & Cons of Investing in Oil
- Potential for returns: While the price of oil and the share value of oil-related investments can have periods of significant volatility, there are potential opportunities for investors to obtain above-market returns.
- Diversification: Exposure to investment types with performance that is not highly correlated to other investments can help to diversify a portfolio. Investing in oil stocks or the energy sector can provide returns that differ from other sectors.
- Inflation hedge: Since prices for commodities, including oil, can rise along with the prices for goods and services in an economy, oil can be used as an inflation hedge.
- Numerous risks: Investing in oil carries additional risk, such as world events, oil price wars, government regulation, technological shifts (such as toward electric vehicles), cyclicality, and economic conditions, many of which can cause sudden and dramatic fluctuation in oil prices.
- Volatility: Mutual funds or ETFs that track a single asset price or sector tend to be more volatile than broadly diversified funds. Purchasing oil futures or options can introduce even more volatility and risk.
Researching Oil Investments
To research oil investments, investors can use a number of research tools, including equity research websites, investment research software, and reading commodities news outlets. Investors may also research various sector funds that invest in commodities and the energy sector.
Tip: Investors looking for indirect exposure to oil investments may use Seeking Alpha’s popular stock rating screener and Quant Model. The energy sector screener allows investors to choose among the top energy sector stocks with the most favorable ratings. Energy sector businesses may include those involved in the production and sale of energy, including oil, natural gas, electric power, and renewable energy.
Investors can gain exposure to oil directly, through the purchase of oil futures or options, or indirectly by purchasing oil stocks or shares of mutual funds or ETFs that invest in oil stocks or the broader energy sector. But investing in oil brings with it additional risks that investors should be aware of before buying.