Hereâ€™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.
Like gold, oil captures the investing publicâ€™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:
Itâ€™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. Thatâ€™s in addition to owning companies that produce the black stuff.
Oil can be a good investment, but investors looking to participate in oil must carefully consider what theyâ€™re looking for.
You donâ€™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.
The futures market might be the best way to own oil if youâ€™re looking to get rich trading. Thatâ€™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. Thatâ€™s excellent when the price of oil is moving your way, but when itâ€™s not, youâ€™ll probably need to add more money to your account to maintain the position. Thatâ€™s the flip side of leverage, but itâ€™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. (Hereâ€™s what you need to know about getting started in the futures market.)
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 donâ€™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 wonâ€™t provide the kind of exponential return of futures unless itâ€™s a leveraged fund â€” hereâ€™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%.
If youâ€™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 â€” as opposed to oil directly â€” is that the companiesâ€™ 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 theyâ€™re generally seen as safe investments. They tend to perform best when oil prices are rising â€” that is, when the economy is doing well.
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 whatâ€™s called the midstream market, moving oil or gas in pipelines across the country. They usually donâ€™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 theyâ€™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.
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:
Itâ€™s surprisingly easy to invest in oil, and you can even pick how youâ€™d like to own it â€” 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 youâ€™re not sure of what oil company to invest in, you can buy the whole sector through an ETF or mutual fund. And it couldnâ€™t be easier to get started investing in funds â€” hereâ€™s how.