How To Invest In Oil?
Investing in oil can be a very confusing concept both for the private investor and sometimes even for the professional. In today’s post, we are going to try to explain as clearly as possible the different investment instruments that can be used when deciding to incorporate this material into the investment portfolio.
What does the price of oil depend on?
First of all, it is essential to understand how this raw material works. The price of oil, like that of other goods, depends on its supply and demand.
On the demand side, it is quite simple, consumers who daily use goods and services that are directly or indirectly related to this matter.
On the supply side, contrary to what most may think, the largest oil producer in the US and not Saudi Arabia. The reason is due to the discovery of the fracking of “bituminous oil” in Texas and North Dakota and the reduction in production in Saudi Arabia due to the constant attacks on its oil fields.
|Country||Daily production (in barrels)|
|Saudi Arabia||9.75 million|
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 36.5 billion barrels in reserve, is well behind other producing countries such as Venezuela (266 billion barrels), Iran (158 billion), Iraq (143 billion), and Kuwait (102 billion). Russia and Saudi Arabia have 98 billion and 80 billion respectively. This information is important to determine future supply capacity and import and export flows.
However, the Organization of Petroleum Exporting Countries (OPEC), founded in the 1960s, made up mainly of Saudi Arabia, Kuwait, Iran, Iraq, and Venezuela, plays a fundamental role on the supply side of crude oil. Although the statute of the organization does not explicitly establish, they fix the prices in the market. If OPEC decides to restrict production, it can force oil prices to rise. On the other hand, if they decide to mass-produce, they can also lower the price, which is the current case.
Investing in oil means assuming a high level of risk, basically, because the producing countries are zones of war and political conflict, so fluctuations can be considerable.
How to invest in oil?
Once supply and demand are understood, it is time to talk about how to operate this raw material. In the following video, we explain in-depth how to invest in oil through 6 stock market instruments.
Storing REAL barrels of oil
First, there is the option of buying and selling crude physically, but it is not recommended for the private investor since they would have to find a place to store it, with extreme care due to its level of toxicity and others.
Oil futures allow you to benefit from fluctuations in the price of a 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 certain date in the future, hence the name.
There are several types of crude oil in the world, but the ones we usually hear the most and those that serve as references are mainly Brent and WTI (World Texas Intermediate).
Crude oil is a commodity traded on the futures market. Specifically in the ICE and the NYMEX, with delivery dates for the twelve months of the year. Each futures contract is made up of 1,000 barrels of crude oil and its tick or minimum price variation is 0.01 dollars per barrel, that is, 10 dollars per contract.
Through this contract, the products of this matter ensure the sale of their barrels and the buyers ensure that they receive the barrels at the current agreed price. However, some speculators try to make money through these types of contracts, trying to sell them before their expiration confident that the price of crude oil will rise ( Oil futures in negative: What happened? ).
The simplified operation is as follows, between two people a contract of 1,000 barrels is agreed at 50 dollars a barrel with expiration in X. Then two cases can occur:
- That the price of the barrel falls before expiration. If for example, the price fell to $49 per barrel, then you would lose $1,000 ($1 x 1,000 barrels).
- That the price of the barrel rises before expiration. If, for example, the price rose to $51 per barrel, then you would earn $1,000 ($1 x 1,000 barrels).
If you are interested in the future, you can take a look at the brokers that offer these products.
Both futures and CFDs (contracts on the difference) are derivatives and offer the same leverage benefits, but while the former has an expiration time, the latter does not, so CFDs are more flexible in this regard. In the future, as they have a specified expiration date, there is the possibility of not having enough liquidity to undo the position at an acceptable cost.
Due to the structure of financing costs, commissions, and opening fees, CFDs are better suited to small, short-term positions, while futures are a better choice for larger, longer-term positions.
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’s important to understand how they work because in some cases, they don’t work as expected. Because ETFs rarely take physical possession of oil, the fund’s return will depend on the expiration of the futures contracts. The main problem with this strategy is that the futures contracts for the current month tend to be lower than the contracts for future months. The result is that the fund typically suffers small losses each month due to the reinvestment process, and over time, those losses can add up to big drops, even when oil prices are steady or trending higher.
ETFs, being based on derivative contracts traded in futures markets, are based on the convergence between future and expected value. Here the concepts of ‘ Contango ‘ and ‘ Backwardation ‘ come into play. ‘Contango’ is considered when the price of the next future is higher than the current one and ‘backwardation’, is the opposite.
Here are some examples of ETFs:
|United States Oil Fund||USE|
|United States Brent Oil Fund||NOB|
|DB Oil Fund||BOD|
|The United States 12-Month Oil||USL|
You have the explanation of each ETF and some more examples in this article: Which oil ETF is better?
Oil Company Stocks
You also have the option of investing 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 in value when crude oil falls. For example, the refinery industry relies on crude oil as an input to produce gasoline, diesel, and other refined products. If crude oil prices rise without a corresponding rise in the price of refined energy products, then investors can expect refiner stocks to fall, because their profits decline.
|International Petroleum Corp.||IPCO|
Perhaps given 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 either but in companies related to the extraction, distribution, and marketing of oil. These companies have a very high correlation with the value of oil but never replicate their behavior.
|Bankinter Energy Efficiency And Environment C FI||ES0114806005|
|First Trust North American Energy Infrastructure Income UCITS Fund Class II USD Distributing||IE00BD0BWT66|
|Investec Global Strategy Fund – Global Energy Fund I Acc EUR||LU0345780109|
|Ibercaja Petrochemical B FI||ES0130706007|
|BlackRock Global Funds – World Energy Fund A2||LU0122376428|
|Goldman Sachs North America Energy & Energy Infrastructure Equity Portfolio R Acc EUR||LU1299707155|