The oil market can be very confusing to both the professional and individual investor, with large price fluctuations sometimes occurring on a daily basis. This article gives a broad overview of the forces driving the oil market and how to have a financial stake in oil in your investment portfolio.

Key Takeaways

  • As a commodity, the price of oil in the market depends on supply and demand, but its supply is somewhat controlled by the OPEC cartel.
  • Different grades of oil trade under different markets such as West Texas Intermediate (WTI) or Brent. It may also be "light" or "sweet" in nature.
  • Oil is sometimes seen as a portfolio diversifier and a hedge against inflation.
  • Buying and selling physical oil is not an option for most investors, but liquid markets that track oil prices can be found via futures, options, ETFs, or oil company stocks.

Demand

The Organization of Petroleum Exporting Countries (OPEC) and the International Energy Agency estimate the current world demand for oil at between 97 million to 99 million barrels per day in 2017. When the price of oil rises, this decreases demand in the United States, but demand from growing emerging market economies is expected to increase as these countries industrialize.

Some emerging market economies have fuel subsidies for consumers. However, subsidies are not always beneficial to a country's economy, because although they tend to spur demand in the country, they may also cause the country's oil producers to sell at a loss. As such, removing subsidies can allow a country to increase oil production, thus increasing supply and lowering prices. In addition, cutting subsidies can decrease any shortage of refined products, since higher oil prices give refineries an incentive to produce products such as diesel and gasoline.

Supply

On the supply side, in 2017, approximately 92.6 million barrels of oil were produced each day. The discovery of new reserves in 2017 was the lowest since the 1940s. The amount of reserves found has fallen every year since 2014 as budgets for oil exploration has been cut following the fall of oil prices.

In OPEC, most countries do not have the ability to pump out much more oil. Saudi Arabia, the one exception, keeps an estimated spare capacity of 1.5 to 2 million barrels of oil per day as of 2018. The United States, Russia, and Saudi Arabia are the world's leading producers of oil.

In the Spring of 2020, oil prices collapsed amid the COVID-19 pandemic and economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows.

Quality & Location

One of the major problems the oil market faces is the lack of high-quality sweet crude, the type of oil that many refineries need to meet stringent environmental requirements, particularly in the United States. This is why, despite the rising production of oil in the United States, it must still import oil.

Each country has a different refining capacity. Such as the United States, which produces a lot of light crude oil that it can export. Meanwhile, it imports other types of oil to maximize its production based on refining capacity. 

There are also differences in terms of where oil is produced for sale. For example, the major difference between the crude oils Brent Crude and West Texas Intermediate is that Brent Crude originates from oil fields in the North Sea between the Shetland Islands and Norway, while West Texas Intermediate is sourced from U.S. oil fields, primarily in Texas, Louisiana, and North Dakota. Both Brent Crude and West Texas Intermediate are light and sweet, making them ideal for refining into gasoline.

Speculation

Aside from supply and demand factors, another force driving oil prices has been investors and speculators bidding on oil futures contracts. Many major institutional investors now involved in the oil markets, such as pension and endowment funds, hold commodity-linked investments as part of a long-term asset-allocation strategy. Others, including Wall Street speculators, trade oil futures for very short periods of time to reap quick profits. Some observers attribute wide short-term swings in oil prices to these speculators, while others believe their influence is minimal.

Oil Market Investment Options

Regardless of the underlying reasons for changes in oil prices, investors who want to invest in oil markets and capitalize on energy price fluctuations have a number of options.The bulk of oil trading takes place in derivatives markets, utilizing futures and options contracts. These may be out of reach of many individual investors, but there are several other routes to add oil to your portfolio. One simple way for the average person to invest in oil is through stocks of oil drilling and service companies. In addition, investors can gain indirect exposure to oil through the purchase of energy-sector ETFs. Several sector mutual funds invest mainly in energy-related stocks are available like the iShares Global Energy Sector Index Fund (IXC), and to energy-sector mutual funds, like the the T. Rowe Price New Era Fund (PRNEX). These energy-specific ETFs and mutual funds invest solely in the stocks of oil and oil services companies and come with lower risk.

Investors can gain more direct exposure to the price of oil through an exchange-traded fund (ETF) or exchange-traded note (ETN), which typically invests in oil futures contracts rather than energy stocks. Because oil prices are largely uncorrelated to stock market returns or the direction of the U.S. dollar, these products follow the price of oil more closely than energy stocks and can serve as a hedge and a portfolio diversifier.

Investors have a number of ETF and ETN options to choose from, such as a single-commodity ETF (e.g., oil only) or a multi-commodity ETF that will cover a variety of energy commodities (oil, natural gas, gasoline, and heating oil). There are many choices for investors.

The Bottom Line

Investing in oil markets means investors have a diverse array of options. From indirect exposure via an energy-related stock to more direct investment in a commodity-linked ETF, the energy sector has something for almost everyone. As with all investments, investors should do their own research or consult an investment professional.