How can I buy oil as an investment?
Investors have many options for getting involved with oil. These methods come with varying degrees of risk and range from direct investment in oil as a commodity, to indirect exposure in oil through the ownership of energy-related equities.
One direct method of owning oil is through the purchase of oil futures or oil futures options. Futures are highly volatile and involve a high degree of risk. Additionally, investing in futures may require the investor to do a lot of homework as well as invest a large amount of capital.
Another direct method of owning oil is through the purchase of commodity-based oil exchange-traded funds (ETFs). ETFs trade on a stock exchange and can be purchased and sold in a manner similar to stocks. For example, buying one share of the U.S. Oil Fund (USO) would give you exposure to roughly one barrel of oil.
In addition, investors can gain indirect exposure to oil through the purchase of energy-sector ETFs, 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.
If you are looking for more information about investing in oil companies, Investopedia's Advisor Insights tackles the topic by answering one of our user questions.
Investing in crude oil requires careful consideration, because you have many different choices. Because crude oil is a physical commodity, directly investing in oil requires proper handling and management of the physical good, and that involves logistics that many traditional investors in the stock market aren't comfortable taking on in their portfolios. There are other ways to invest in crude oil that offer simpler handling, and they have advantages and disadvantages as well. Among the ways to invest in crude oil are:
- Owning physical crude oil itself.
- Investing in crude oil futures contracts that give you the right to take future possession of the physical commodity.
- Investing in exchange-traded funds that seek to track the price of crude oil.
- Investing in energy companies that explore for, produce, transport, refine, or sell crude oil.
We'll look at each of these investments in a little more detail and look at the “pros and cons” as there is no perfect investment. Some of these investments can be owned in IRAs as well, but may have issues (such as Unrelated Business Income Tax or UBIT) or the need for a Self-Directed IRA).
Owning Physical Crude
Owning actual crude oil ensures that the value of your investment will rise or fall with the market price of crude, but it's very difficult for the ordinary investor to do. Storing crude oil requires special handling because crude oil is toxic and volatile. Typical storage facilities include rail tankcars and the huge oil storage tanks that you see near refineries and pipelines, and the sheer volume of crude is more expensive than most ordinary investors want to invest. Add in storage fees, and the shortcomings of directly owning crude outweigh the advantages for most investors.
The physical component can also be done by owning a shares in oil and/or gas wells (these can be tricky and typically come with a K-1. If in an IRA, this would have to be done in a Self-Directed IRA. If done in a taxable account, you may have the ability to take some income tax deductions related to tax-breaks such as deductions for IDCs or Intangible Drilling Costs, etc.
Investing in Crude Oil Futures Contracts
Crude oil futures contracts offer a method for investors to get exposure to price of crude without having to deal with the storage and other issues involved in owning the physical commodity. Futures contracts let you arrange to buy or sell a certain amount of oil in the future, with the price fluctuating with the market. If you buy a futures contract and the price of crude goes up, then you profit. If it falls, then you'll lose money, and the contract seller will end up being the one to make money on the contract.
Crude oil futures contracts give investors the chance to have a highly leveraged investment. For instance, the contract unit for CME Group crude oil futures is 1,000 barrels, currently worth around $50,000. However, the current maintenance margin required is just $2,500, meaning that you only need about 5% of the total contract value in your futures brokerage account. That doesn't prevent you from suffering losses above that amount, however, so it's important to understand that this leverage is a tool that can work for or against you. These investments using futures contracts typically create UBIT and you should take care when owning these investments in an IRA.
Investing in Crude Oil ETFs
Exchange-traded funds make it easier for investors to invest in certain areas, and there are crude oil ETFs that offer exposure to the price of the commodity. However, it's important to understand how such ETFs work, because in some cases, they won't perform the way you might expect and can therefore be disappointing over the long run. This is especially true when using “leveraged ETFs” that give you multiples of the daily price changes in Oil.
The United States Oil Fund (USO) the best-known oil-tracking ETF, with the goal of moving up or down in line with the price of West Texas Intermediate crude oil futures on a daily basis. The fund does a good job of accomplishing that goal, but what it doesn't do is track longer-term changes in crude. Because the ETF doesn't want to take physical possession of crude oil, it simply rolls futures contracts forward when one expires. The main problem with that strategy is that futures contracts for the current month tend to be less expensive than contracts for future months. The result is that the fund usually takes small losses every month because of the rollover process (many times called a “roll-risk”), and over time, those losses add up to become very large declines -- even when oil prices are flat or trending higher.
Owning Stocks of Companies in the Crude Oil Business
The best way for most investors to invest in crude oil is through the companies that explore for, produce, transport, refine, and sell crude. Some of these companies, such as exploration and production companies, tend to rise in value when crude climbs and fall in value when crude drops. Other parts of the industry have more complex correlations with crude prices. For instance, the refinery industry relies on crude oil as an input for producing gasoline, diesel fuel, and other refined products. If crude oil prices rise without a corresponding increase in the price of refined energy products, then investors can expect refinery stocks to fall, because their profits go down.
Individual stocks are available for investors, but you can also buy energy ETFs that own a wider variety of stocks in the industry. By choosing companies that can profit both from rising oil prices and through smart operational decisions, you can increase your chances of investing successfully.
Investing in crude oil has plenty of profit potential, but you should focus on the methods of investing that work best. Most investors are most comfortable finding stocks that will benefit from crude oil movements rather than buying crude directly on their own.
I like baskets of companies because of acts of Gods. ie you can do all the research you want but you can't predict a political event, natural disaster or in some cases fraud. The two investments I like are USO, an ETF, that represents a basket of investments in oil or oil futures and a better "less risky" investment AMLP, which is an ETF that invests into an index of oil and gas pipelines. This ETF is one that I own for clients that pays approximately a 9% dividend, is a basket of 23 companies. These companies have been hurt due to low oil prices, but they act as a toll booth on a highway that always makes money as oil & gas passes its pipeline. In addition, this asset class has 20% upside when oil prices normalize between 60 and 80 per barrel.
Assuming you’re a retail investor, who wants to allocate a portion of your investment in the energy sector, the easiest way to do is through mutual funds or ETFs (Exchanged-Traded Funds). In doing so, you are not buying one or two energy companies alone, you invest the entire energy sector, from the oil exploration, drilling, refinement, transportation, and storage. The key is to find the low-cost and diversified energy sectors for your money worth. Happy investing!
Besides owning physical crude oil, there are 3 ways for an investor to gain exposure to the price movements of oil:
- Investing in oil futures contracts
- Investing in commodity Exchange Traded Funds (ETFs) that track oil futures
- Invest in an oil sector fund or buy the stock of companies whose primary business is related to oil
1) Investing in oil futures contracts is an efficient way to directly invest in oil as a commodity. This type of strategy is best suited for accredited investors because it carries a higher degree of risk and is generally more capital intensive than the other two investment alternatives. Basically, investors who buy/sell oil futures are agreeing to buy/sell oil at a future price. Meaning the difference in price between the day the futures contract is bought versus the price on the day the contract expires is the profit or loss realized to the investor. For example, say an investor buys a futures contract, that person profits when the price of oil goes up. Whereas, the opposite is true if the price goes down. For investors who sell futures contracts, they profit when the price of oil goes down and lose money when the price goes up.
2) Oil commodity ETFs such as USO and DBO can be an effective way for everyday investors to get indirect exposure to the daily price movements of oil futures like the West Texas Intermediate crude. ETFs offer the investor liquidity because they are readily traded like a stock on the major exchanges. However, it is important to note that these type of ETFs are better-suited for day traders because of the long-term deviation from the price of the commodity itself. This difference in value occurs because there is a cost to the fund whenever futures contracts expire and need to be renewed. In other words, these transaction costs can add up to a significant amount in the long-term and is why a "buy-and-hold" type of investor should beware.
3) The most common way for investors to get access to the price movements of oil is buying sector ETFs like iShares Global Energy (IXC), or buying individuals stocks in the crude oil business like Exxon (XOM). To a certain degree, investors are able to experience a high-level of correlation between the price movements of crude oil and the profitability of companies within the oil sector. Some companies are more efficiently run than others, which will have a direct impact on those companies' ability to generate profits. It should also be noted that buying a sector fund gives the investor better overall diversification versus owning an individual company. On the other hand, buying a single company allows an investor to exclude any number of companies that appear unattractive within the oil sector.