How to invest in oil

With energy transition away from fossil fuels a hot topic around the world, it is not unreasonable to think that global demand for oil is declining.

That's not true. Various estimates suggest that oil demand will begin to decline shortly before 2030, sometime during that decade, or even by the mid-2040s. Everyone agrees that oil demand will increase in the coming years.

“Despite the growing attention on green energy, oil remains a global commodity that is being used in greater quantities than ever before and currently offers high-margin, high-return opportunities,” said Matt Wheeler, managing director at Phoenix Capital Group Holdings, an oil and gas investment firm.

For investors looking to get involved in a riskier market, this primer provides an overview of how to invest in oil.

Understanding the oil market

The oil market is global and is influenced by supply and demand factors, geopolitical considerations and government actions. It is important to understand that, like any other commodity, oil prices are highly volatile.

What is Crude Oil?

Crude oil is a fossil fuel, like natural gas and coal: a hydrocarbon that formed over millions of years as sand, silt and rocks covered the remains of animals and plants that lived before the dinosaurs.

Companies in the oil supply chain extract crude oil from the ground, transport it, and refine it for use in many of the products that underpin our economy, including car and aviation fuel, heating fuel, asphalt, lubricants, plastics, and solvents.

“Oil plays a vital role in providing low-cost energy, contributing to growth and rising living standards,” said Jeff King, portfolio manager at Macquarie Asset Management. “From pharmaceuticals to plastics, oil's uses permeate our daily lives more than most people would imagine.”

Different ways to invest in oil

There are multiple ways to invest in oil, with varying levels of suitability depending on an investor's sophistication, risk tolerance, and purchasing ability.

Methods include buying shares in oil and gas companies, such as producers, refiners, and master limited partnerships (MLPs).

Mutual funds and exchange-traded funds (ETFs) make this process easier by combining multiple stocks into one investment.

Some funds also offer exposure to crude oil futures, which can be an easier option for retail investors than the complicated process of trading futures directly.

“If I wanted low-cost, diversified exposure to energy, I'd buy an ETF, but if I was looking for yield, I might buy top-tier dividend stocks,” Wheeler said. “If I was looking to hedge, I might look at options or futures, but it all depends on what my initial objectives are.”

stock

Oil producers like Exxon Mobil (XOM), Chevron (CVX), and Shell (SHEL) are well known.

These are vertically integrated companies, meaning they are involved in the oil supply chain from exploration, production, refining, transportation, marketing and sale to end users. In addition to stock price appreciation, investors can also benefit through dividends from these companies.

Other ways to invest in oil stocks include companies that focus on just one part of the supply chain, such as exploration and production companies (MLPs). MLPs are tax-advantaged, yield-focused infrastructure companies that essentially issue exchange-traded funds (ETFs) that function as shares.

“Investing in oil through equities provides investors with exposure to oil as a commodity while also providing the opportunity to benefit from management's expertise in allocating capital through existing assets, new assets or capital returns,” King said.

Mutual funds and exchange-traded funds

To minimize company-specific risk, investors can consider mutual funds or ETFs that pool a variety of stocks under one ticker symbol.

Mutual funds that include oil companies include Vanguard Energy Fund Investor Shares (VGENX) and Integrity Mid-North American Resources Fund (ICPAX), while ETFs include the Energy Select Sector SPDR Fund (XLE) and Vanguard Energy ETF (VDE).

Besides stocks, there are ETFs that invest in crude oil futures, such as the United States Oil Fund (USO), which tracks the performance of the near- or next-month West Texas Intermediate (WTI) crude oil contract.

futures

Funds that hold futures contracts can be bought and sold on an exchange like stocks, making them easier for investors to handle than buying futures themselves.

Oil futures are contracts to buy and sell oil at a specific price at a specific time in the future. Trading oil futures is complex and not for the faint of heart. There is a significant learning curve involved, including margin, leverage, and contract rollovers.

Benefits of investing in oil

The main benefit of investing directly in oil through futures contracts is the potential for price increases. When oil prices rise, futures contract holders benefit. These assets act as an effective inflation hedge during booming economic times.

This rise in prices benefits individual companies as well as oil stocks and futures funds.

Dividends and share buybacks are benefits to investors who hold shares in oil companies, as oil companies in recent years have focused on returning capital to shareholders through stock buybacks and dividend payments, and have refrained from drilling, which could cause oil prices to fall as supply increases.

Even if oil prices remain stable, oil stocks may still outperform oil prices as companies are able to increase their cash flows through greater efficiency.

Risks of Oil Investment

Besides the risks associated with trading oil futures contracts, there are also company-specific risks, such as making poor business decisions, overpaying for an acquisition, or running up budget on an exploration project.

Oil prices could also fall for a variety of reasons, including worsening macroeconomic forecasts, increased production by the Organization of the Petroleum Exporting Countries (OPEC) and its allies, and easing tensions in the Middle East. There is also a risk that economies will move away from oil dependency sooner than expected.

“In the short term, the main risk of investing in oil is buying at the wrong time in a cycle when supply is increasing or demand is decreasing,” King said. “In the longer term, some investors believe that oil will play a smaller role in the economy as alternative energy sources increase, and that demand for oil may become structurally lower.”

A sustainable alternative to oil investment

Investors who are concerned about the ethics of investing in oil companies amid climate change, or who simply want to diversify their energy holdings, could consider investing in renewable energy companies.

These include solar, wind, geothermal and biomass companies, as well as companies involved in battery, green hydrogen and clean energy technologies. Green energy alternatives act as a hedge against an eventual decline in oil demand. Higher oil prices also make alternative energy companies' products more attractive, so the value of these companies is likely to rise along with the price of oil.

Solar and wind power companies have struggled recently as high interest rates have increased the cost of borrowing for large capital investment projects.

“Investors can get into the energy sector in a variety of ways, including investing in renewable energy companies,” King said, “but many of these companies are exploring complex or new technologies, so these investments can involve greater risk.”