Friday, 23 October 2020

How to Trade Oil

How to Trade Oil
08 Feb
12:49
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Oil has been a popular investment for a long time, but there are many ways to invest in the oil patch. Investors looking to start trading oil should know the different kinds of investments available — each offering a range of risks and returns — so they find what suits their needs best.

Here’s why oil is so popular as an investment, four different ways to trade oil and an explanation of what moves the price of oil.

What makes oil such a popular investment?

Like gold, oil captures the investing public’s imagination, but there are many fundamental economic reasons investors trade in oil. Some of the most common reasons to invest in oil include the following:

  • Basic supply and demand: The short answer is that oil is fundamental to economic growth, and aggregate global demand continues to grow. Oil will be in demand for years, providing some safety to investors who buy it and companies that produce it.
  • Speculation: Because it allows increasing levels of productivity, oil is one of the key ingredients of Western-style economic growth. Speculators are ready to bet on the price of oil when events threaten to interrupt supply or demand flags. If there’s a clear move in the price of oil, then speculators can make a lot of money very quickly.
  • Hedge: Sophisticated investors may use oil as a hedge against other investments they own. For example, if one of a company’s main inputs is oil, an investor may buy oil futures to counteract the negative effect of rising oil prices on the company. Similarly, a company may hedge its dependence on oil by buying oil futures, or if it produces oil, it may sell oil futures and lock in prices today at a level it finds attractive.
  • Growth potential: Investors may buy companies that have a track record of finding and developing oil, and they may invest in fast-growing segments of the oil market, such as fracking. While oil normally is not thought of as a growth industry, certain well-run companies within the sector may be growing quickly.
  • Defense: Oil can act as a defensive investment because of the sustained demand for it and its absolute centrality in economic growth. Oil is not going away anytime soon.

It’s now easier than ever to own oil investments, and you can even own oil directly through exchange-traded funds (ETFs) or via the futures market. That’s in addition to owning companies that produce the black stuff.

Getting started: 4 ways to buy and sell oil

Oil can be a good investment, but investors looking to participate in oil must carefully consider what they’re looking for.

  • If you’re looking for long-term gains, investing in the stocks of well-run oil-producing companies or funds holding those companies can create attractive long-term gains. Some of the market’s largest businesses — Exxon Mobil and Chevron — are oil companies, and so are some of the market’s highest dividend payers.
  • If you’re looking for short-term trading profits, oil futures and funds owning oil directly will be what you’ll turn to. While the price of oil may go up over time, it doesn’t create the kind of buy-and-hold returns you can earn with companies. Instead, the price fluctuates a lot, meaning you’ll need to trade your way to wealth.

You don’t have to go dig a hole to invest in oil, and there are at least four ways for individual investors to gain exposure to the black stuff in publicly traded securities.

1. Oil futures

The futures market might be the best way to own oil if you’re looking to get rich trading. That’s because futures allow you to leverage your equity stake and own much more oil than you otherwise could. Futures get you in the game while requiring you to put up just a small portion of the total value of the contract.

This leverage means that a relatively small move in oil will result in a huge move in your total position. That’s excellent when the price of oil is moving your way, but when it’s not, you’ll probably need to add more money to your account to maintain the position. That’s the flip side of leverage, but it’s what make oil futures interesting to traders.

Oil futures are geared toward traders, not long-term buy-and-hold investors. Futures contracts expire after a given time, and the volatile price of oil means that gains may evaporate quickly. (Here’s what you need to know about getting started in the futures market.)

2. Oil ETFs and mutual funds

Oil ETFs and mutual funds own two major types of oil assets. They own stocks of oil companies or crude oil via futures and other derivatives.

First, like typical funds, oil-focused funds can own the individual stocks of oil and gas companies, refiners, and any number of associated companies operating in the oil space. For investors looking for buy-and-hold investments that can create enduring value, this kind of fund should prove attractive. And it should be interesting to investors who want exposure to oil companies but don’t want to select individual stocks. This kind of ETF gives immediate diversification across the industry.

Popular ETFs holding oil stocks include Energy Select Sector SPDR Fund (XLE), Vanguard Energy ETF (VDE) and SPDR S&P Oil & Gas Exploration & Production ETF (XOP). Their expense ratios are on the cheaper side, ranging from 0.1% to 0.35%.

Second, these funds may own crude oil through derivatives. The typical objective of this kind of fund is to track the daily price movement of oil, and this is done through the use of futures and similar contracts. This kind of fund might prove interesting to investors who cannot access the futures market directly, but the fund won’t provide the kind of exponential return of futures unless it’s a leveraged fund — here’s what that means. This kind of oil investment is more for traders than for long-term investors.

Popular ETFs holding crude oil include United States Oil Fund (USO), VelocityShares 3x Long Crude Oil ETN (UWT) and ProShares Ultra Bloomberg Crude Oil (UCO). Their expense ratios are on the high side for ETFs, ranging from 0.77% to 1.5%.

3. Oil stocks

If you’re more of an advanced investor, you may opt for owning individual stocks rather than funds. Your expertise can allow you to identify the companies that are likely to be the biggest winners in the industry and avoid some of the lesser companies. That should help boost your overall return as well.

The advantage of owning companies — as opposed to oil directly — is that the companies’ profits are leveraged to the price of oil. As the price of oil rises, company profits go up much more. For example, while oil may rise 10%, profits might increase 25%. And proved reserves may help keep a floor under the stock price too.

The big oil companies are called supermajors, and they are integrated companies that have businesses up and down the oil chain. They develop and produce oil, refine it, and make other oil-based products. The biggest American companies include Exxon Mobil (XOM), Chevron (CVX) and ConocoPhillips (COP), and they’re generally seen as safe investments. They tend to perform best when oil prices are rising — that is, when the economy is doing well.

4. Oil MLPs

Another class of oil company is called an MLP, or master limited partnership. These are partnerships that trade publicly on an exchange like a stock and usually are formed for the purpose of providing an attractive and growing cash distribution. Most typical MLPs operate in what’s called the midstream market, moving oil or gas in pipelines across the country. They usually don’t produce or refine oil but help it get from one place to another, often with contracts that guarantee a certain revenue.

This steady business allows MLPs to make cash payouts, ensuring their popularity with income investors. However, because they’re partnerships, they often present tax headaches for those unfamiliar with them. MLPs tend to be conservative investments, with the business tied less to oil prices and more to how much oil the company moves.

What factors influence the price of oil?

Sometimes it feels like oil is the most sensitive commodity in the market. Its price seems to move on almost any news but especially bad news. Beyond basic supply and demand, here are some of the major factors that drive the price of oil:

  • Economic growth: Economic growth tends to lead to greater demand for oil, pushing up its price. Even the expectation of greater growth could lead to investors bidding up the price in anticipation. Conversely, a decline in economic growth or a recession could put downward pressure on oil prices.
  • Supply disruptions: Anything that threatens to disrupt the supply of oil will tend to move the price higher. The market becomes remarkably jittery when war breaks out, for example, and prices usually move higher even in anticipation. Given that global oil supply is not much higher than demand, it doesn’t take much (potential) disruption to make the market nervous. And of course, oil wells eventually run out, meaning developers have to constantly look for the next new source.
  • Geopolitics: Geopolitics can hit both demand and supply, threatening or boosting either, depending on the circumstances. Trade deals that increase overall economic activity may tend to increase demand, while trade tensions or outright hostilities may threaten supply.
  • OPEC: The Organization of Petroleum Exporting Countries (OPEC) is a cartel that exists to limit production and maximize profits for its 14 members. OPEC may agree to alter production (often based on geopolitical concerns) and is interested in maintaining a high price for oil as long as the price doesn’t encourage alternative fuel sources or drastically inhibit economic growth.
  • Currency moves: Oil is priced in U.S. dollars, so a strong dollar makes oil expensive for all countries that don’t use the dollar. All else equal, higher oil prices inhibit economic growth. Conversely, a weaker dollar makes oil cheaper for much of the world.
  • Speculation: Regardless of the economic fundamentals, speculators can push the price up or down. That has follow-on effects on the real economy.

Bottom line

It’s surprisingly easy to invest in oil, and you can even pick how you’d like to own it — from the low-return conservative approach to the high-return risky approach. Even dividend investors can find something to like in the oil sector, with MLPs offering high and growing yields. If you’re not sure of what oil company to invest in, you can buy the whole sector through an ETF or mutual fund. And it couldn’t be easier to get started investing in funds — here’s how.

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James F. Royal, Ph.D.

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Source: https://www.magnifymoney.com/blog/investing/how-to-trade-oil/

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