As of July 2023, we believe oil stocks are an attractive investment (via the energy ETF XLE). As we wrote in April, “energy companies continue to emphasize returning cash to investors over ramping up exploration and production. Returns will come via higher dividends and share buybacks.”
On oil as a commodity, we are neutral in our prime portfolio. Chinese oil demand has been strong. However, inventory builds combined with ‘surprise’ oil production increases from Iran and other sanctioned countries have prevented the oil price from rising. This cuts off the right tail in oil prices for the second half of this year.
Investors can find all the latest insights into oil investing in the commodities section of our website.
Understanding Oil Investing (A Beginner’s Guide)
Oil stocks can be a good investment if oil prices are expected to rise. However, many factors can influence performance, and there are many ways to invest in oil. Here are the most common ones:
Those looking to have direct exposure to oil usually do so through future contracts. There are many oil futures that investors can purchase and sell. The most common one is the Brent Crude. Initially, it benchmarked the output from Brent oil fields. Now, numerous oil fields are included in the contract, with the Texas fields being the most recent addition.
The main thing is that most of the oil futures (and all if you are a retail investor) are settled in cash. Investors do not have to take delivery of the oil itself once a futures contract expires.
This also means that the future contract can be sold and bought anytime. When you purchase a contract, you are trading the contract itself and not the underlying commodity (oil, in this case).
However, futures trading is risky and not ideal for most novice investors. An example is during the COVID-19 pandemic when gasoline futures prices went negative due to low demand and massive supply. Therefore, investors with more conservative risk management may want to consider other options.
Lastly, remember that oil options can also be used with a few other derivatives to invest in the commodity. However, this is still extremely risky and should not be attempted by those new to investing.
Oil stocks are companies related to oil production, distribution, and sale. Owning these companies is another way to gain exposure to oil because the company’s performance is correlated with the price of oil. For example, Standard Oil stock will increase in price if the crude oil prices go up because the company can now sell petrol at a higher margin.
Not all oil stocks are created the same. For example, those producing petrol from crude oil are much safer bets than companies involved in drilling. Companies that drill for oil have a greater chance of not finding oil as they explore potential oil fields. Of course, these companies also have a much greater upside if they strike oil.
For new investors, oil funds are perhaps the most straightforward and least risky way to gain exposure to oil. Oil funds are usually diversified across a wide variety of oil-related assets. Certain funds might be invested in oil companies, while others may have a futures-heavy portfolio.
Oil ETFs can appeal to investors wanting to invest in oil as they are more liquid than other funds. However, conducting extensive due diligence and analyzing the energy assets the ETF invests in is essential.
One more thing to remember is that while an oil fund is diversified, it is only diversified in energy-based assets. As such, investors holding an oil fund may experience large losses if the oil industry were to tank. While it may be appealing to gain exposure to oil, a prudent course of action is to diversify by investing in other industries as well. This can be easily done through index and mutual funds.
Benefits and Risks of Investing in Oil
Here are the pros and cons of investing in oil.
- Oil stocks can often be inversely corelated with the wider stock market. Even if the stock market is undergoing a correction, oil stocks would perform well if prices stay stable or rise.
- Energy equities are liquid. Some of the largest companies, such as Exxon and Chevron, for instance, have large market caps, making them easier to buy and sell.
- 10% of GDP is related to oil consumption, so demand is unlikely to disappear in the near future.
- Oil is an inherently volatile asset, and its volatility makes it risky. A perfect example of this is the onset of the energy crisis after Russia invaded Ukraine in 2022.
- While there is a lot of fundamental data available about the energy sector, its performance is impacted by external factors. Geopolitical shifts such as economic sanctions can have a massive impact on the price of oil.
- The environmental impact of fossil fuels causes a lot of concern to many potential oil investors. While this does not have a direct impact on the price, this does sometimes dissuade investors from going into oil.
Key Factors to Consider Before Investing in Oil
Here are the major factors that investors should be wary of before they invest in oil:
Consider the Dividend
Dividend investing is a great way for investors to accumulate wealth slowly while enjoying regular payouts. Oil companies, especially the larger ones, usually provide a decent and reliable dividend.
However, the dividend is slightly less guaranteed when it comes to oil stocks than defensive stocks. Because of the above reasons, price shocks and choppy markets may lead to even the larger companies experiencing a loss. This may cause them to decrease or even eliminate the dividend.
Decide on an Investment Strategy
It is possible to invest with both long and short-term investment goals. And investors can also consider whether they would like exposure to oil as a commodity or via oil company stocks.
For example, we are neutral on crude oil for 2023 as industrial demand is slowing. However, OPEC+ production cuts are beginning to tighten the physical market. Dubai crude now trades at a premium to Brent, encouraging global refiners to increase imports from elsewhere (e.g. the US) or draw down inventories. This may prompt us to change our outlook on a longer horizon.
Deciding how diversified you want to be is a key consideration when looking at oil stocks. Here, there are two factors to watch out for. The first is how diversified you want to be within the energy sector itself, and the second is your general portfolio diversification.
Considering that oil markets can be unpredictable, avoiding putting all your eggs in one basket makes sense. A safe way for novice investors is to have a decent percentage of their portfolio in oil funds and the rest in other sectors.
Consider Other Opportunities
Oil is a finite resource with a significant impact on the climate. As such, the world is trying to shift away to alternative energy resources such as solar and nuclear. While it is clear that oil is here to stay for at least a few decades, investors could also look at other energy stocks.
How to Invest in Oil
Now that we have discussed the basics of oil investing, here is a step-by-step guide on how to get started:
- Decide whether you want to invest in oil through funds, stocks, or futures. For beginners, funds and stocks may be the better option.
- Decide how much exposure you want to the sector.
- Decide which stocks or ETFs you are going to invest in. Remember that proper research and due diligence are fundamental, even if you think the sector is in for a long bull run.
- Oil stocks and ETFs can be purchased through a regular brokerage or investment app. Simply load up the app, size your position, and invest.
- You may need to request that derivatives be enabled on your investment account to purchase oil futures. This is because derivatives are considered advanced instruments, and there are specific terms and conditions that most investors need to meet before they can invest.
How to Invest in Oil Futures?
Oil futures are available on most brokerages. However, many require additional consent from the investor as futures are risky, and the potential for losses is considerable.
How to Invest in Oil With Little Money?
Investing in oil without much money is usually done by purchasing oil funds (e.g., oil ETFs). Recently, fractional ownership of shares is also possible through special investment apps.