There are many ways to make a profit from crude oil, but not every investment method is suitable. Learn about crude oil futures, options, stocks and funds, and which ones you should choose.
Investing in crude oil can have many outcomes. Crude oil can be wildly speculative, with the potential to earn – or lose – millions in a flash.
As an owned asset, crude oil can offer higher-than-average dividends while protecting against inflation.
Of course, which of these outcomes you get depends on how you invest in crude oil.
In this article, we’ll introduce the complex world of crude oil investing, and break down the different investing methods available.
You’ll learn about:
- What is crude oil and why is it so popular among investors?
- How crude oil performs as an investment
- How to start investing in crude oil
What is crude oil, and how did it become such a popular investment?
Crude oil, otherwise known as ‘black gold’, refers to a type of fossil fuel that is extracted from the ground or seabed.
Composed of hydrocarbons and other organic materials, crude oil can be processed and refined into various usable products, including gasoline, diesel, liquefied petroleum gases and kerosene.
These products and by-products are known as petrochemicals, and besides for fuel purposes, have many other practical applications in our world today. Some everyday products that use crude oil include plastics, waxes, grease, detergents, dyes, inks and solvents – just to name a few out of several thousands.
Another important property to know about crude oil is that it is non-renewable, and supply is limited.
With this combination of scarcity, and the widespread use and reliance throughout the world, it didn’t take long for speculators and investors to start trading and investing in crude oil, realising the inherent value of this important resource.
How does crude oil perform as an investment?
Source: Trading Economics
Here’s a price chart showing the historical price data of crude oil, in US Dollars per barrel.
As you can see, for a critical commodity that virtually the entire world depends on, crude oil is terrifyingly volatile.
Things must have been especially interesting between June 2008 and January 2009, when prices shot up to a record US$140 per barrel, then crashed to US$40 per barrel – wiping off US$100 per barrel in a mere six months!
True, highly volatile assets are challenging, and may not be suitable for everyone. However, high volatility also means greater opportunities to get rich overnight.
Besides, when dealing with a volatile asset class, there are several strategies and methods investors can use to hedge against losses while maximising their profitability.
Before you decide if investing in crude oil is right for you, have a look at the pros and cons we’ve summarised in the following table.
|Good potential for spectacular returns, dividend payments can be higher than average||Sensitive to world events, such as conflict, market movements, regulations and technological shifts|
|Can be used to protect against inflation (since price tends to rise along with inflation)||Has higher volatility that many other investment assets|
|Standalone asset class, can be used to offset exposure in other assets|
How to start investing in crude oil?
There are a few methods you can use to start investing in crude oil, ranging from interacting directly with the commodity’s price, to gaining indirect exposure to the sector through equity or a fund.
We’ve categorised the common methods in the matrix below; let’s go through them one by one.
|Higher risk||Futures and options, oil commodities funds||Buying shares of oil companies|
|Lower risk||n/a||Energy ETFs and mutual funds|
Futures, options and commodities funds
One of the most popular methods of investing in crude oil is via futures and options, due to the potential for large, quick gains. This is considered a direct method of investment, where you are interacting with the price of the commodity.
As you may recall from our other trading guides, futures are agreements to trade the underlying asset on an agreed future date, whereas options allow the investor the right to buy (or sell) the asset. For both futures and options, the outcome depends on the price of oil.
Profiting from futures and options requires a high amount of knowledge and skill to be successful.
Commodities funds are another method of directly investing in crude oil. This basically means buying shares of a fund that attempts to track an underlying crude oil index. You’ll make a profit or a loss accordingly as the price of crude oil swings up and down.
While buying shares of a commodities fund is simpler and more straightforward than trading futures and options contracts, you are still exposed to the price volatility of crude oil.
For this reason, investing in oil commodities funds is considered high risk, and may not be suitable for all investors.
Buying shares of oil companies
Turning now to indirect investment methods, there are also other options like the stocks and shares of oil and gas companies instead. You will turn a profit when share prices rise, or when you receive shareholder dividends.
Oil companies tend to provide higher-than-average dividends during good times – this is also why oil stocks can be attractive. However, if the oil company meets a tough period, dividend cuts are highly likely.
But beyond dividend cuts, profiting with oil stocks is not exactly a straightforward task. You see, there are many different types of companies that interact with crude oil at different points of its journey – from prospecting and discovery to extraction, processing and selling.
Generally speaking, oil companies can be categorised into one of the following:
- Upstream oil and gas companies
Also known as exploration and production companies, these companies prospect for oil around the world. Once they discover oil in a suitable location, they will drill wells and begin extracting the oil for sale. Upstream oil companies are the most susceptible to the changes in the price of crude oil.
- Midstream companies
These companies are involved in the transport, processing and storing of crude oil, natural gas, natural gas liquids and refined petroleum products. As they often do business on fixed-rate, long-term or take-or-pay contracts, midstream oil companies can withstand greater fluctuations in the price of crude oil.
- Downstream companies
Downstream oil companies are involved in refining crude oil into other products, such as fuel or petrochemicals, as well as the sale of such refined products to consumers. Some common examples of downstream companies are gas station operators and refinery operators. Share prices of downstream companies can take a hit when oil prices fall.
- Integrated companies
Oil companies that are involved in more than one of these segments discussed above also exist in the oil supply chain. These are known as integrated companies.
- Oilfield services companies
Lastly, we have oilfield services companies, which are involved in providing equipment, operational support and other related services to upstream companies. As oilfield services companies depend on upstream companies for business, they are affected when oil prices are low, as this triggers upstream companies to reduce service costs.
Hence, investing in crude oil by buying company stock can be tricky, as you’d need to have the right mix of companies to hedge against losses and achieve synergy and profitability.
Also, you might require a large amount of capital in order to achieve and maintain the right balance of stocks.
Energy Exchange-Traded Funds (ETFs) and mutual funds
So far, it seems like investing in crude oil is no simple matter. Luckily, there’s still one more avenue available, and this one is made for investors of all skill levels.
Rather than exposing yourself directly to the volatile price action of crude oil, or attempting to collect the right stocks, you can try investing into a mutual fund or exchange traded fund (ETF) based on the energy sector.
Such funds will have holdings that are composed of oil and gas companies, along with other entities in renewables such as solar or wind power, utilities providers and other energy-related sectors and markets.
Energy ETFs lower your risks as your exposure is spread out over many markets, some of which are hedged against each other. Also, buying into an ETF is typically much more affordable than buying up your own stock collection. You can invest into many different companies with just a small amount of capital.
While ETFs and mutual funds come with fees, you can at least be assured that the professionals are in the picture, and can simply sit back and enjoy any capital growth or dividends as they come.
However, you should also be prepared for energy ETFs and mutual funds to underperform the prices of crude oil, but that’s the price to pay in exchange for lessened volatility and risk.
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By Alevin Chan
An ex-Financial Planner with a curiosity about what makes people tick, Alevin’s mission is to help readers understand the psychology of money. He’s also on an ongoing quest to optimise happiness and enjoyment in his life.