Oil prices have soared in the aftermath of the war between the U.S. and Iran. Some analysts are worried it could become one of the largest oil supply shocks ever.
In the short term, Americans will have to cope with higher oil and gas prices. But that may also lead to higher profits for companies producing oil and rising prices for oil-related assets.
But even if consumers reduce their use and supply begins flowing again, the global economy will be reliant on oil for decades, ensuring that prices will never dip too far for too long.
Savvy investors can profit from soaring oil prices. Whether they’re looking for a defensive hedge for their portfolio or are looking to make a directional bet on oil prices, investors have a variety of options.
Here are five ways to invest when oil prices are volatile, from oil stocks and exchange-traded funds (“ETFs”) to futures.
5 Ways to Invest in Oil
1. Oil ETFs
Oil ETFs give investors exposure to oil price movements, whether they go higher or lower. An oil ETF may own oil futures or options contracts on oil, not the petroleum itself. So, the fund is designed to move in line with the price of oil, but it won’t track the price perfectly because of how it invests.
How you can win: An oil ETF can be an easy way to bet on oil without doing the heavy lifting of investing in futures or options yourself. Your profit potential depends entirely on the price movement of oil. Other options below offer multiple ways to win and more potential upside.
Potential investments: United States Oil Fund (USO), Invesco DB Oil Fund (DBO), ProShares K-1 Free Crude Oil Strategy ETF Fund (OILK).
Risks: Oil can be volatile, and what goes up may come down just as fast. Oil ETFs may be a better fit for short-term traders rather than buy-and-hold types since they tend to lose value over time due to the costs of rolling their options and futures contracts. Because these funds don’t own oil directly, they may experience tracking errors that drift from the spot price of oil.
2. Oil Futures
Of course, you can do what the ETFs do on your own — trade futures and potentially make a bundle if you play it right. Futures are a popular way to trade commodities, but you may need some extra approvals from your broker to get started in this area.
With futures, you agree to buy oil at some specific time in the future. When you buy the contract, you put up only a fraction of the deliverables’ total value. But you’ll have to maintain a minimum margin, or the broker will require you to put up enough cash to reach it if oil moves against you.
How you can win: Futures allow you to leverage your capital, meaning if oil prices rise, your contract’s value will rise even faster. With futures, you won’t even need to put more money into the trade as long as you maintain that minimum margin required by your broker. You also have micro and mini contract types if your bankroll is not quite large enough to trade 1,000 barrels per contract.
Potential investments: Crude oil futures, micro WTI crude oil futures, e-mini crude oil futures
Risks: The key risk of futures is just the flip side of the benefit: If oil moves against you, you lose money even faster. If your account value falls below the minimum margin, you’ll need to put up more money to hold the contract. Otherwise, the broker will liquidate your position.
With oil prices being volatile even during stable times, trading futures requires higher risk tolerance.
3. Oil Stocks
Oil stocks can be a good way to play rising oil prices. These companies pump it out of the ground and therefore profit directly from the rising price. Not all oil companies are created equal, however. You’ll need to research which firms are well-positioned, such as with low-cost wells.
How you can win: Oil exploration and production firms give you two ways to win with oil. First, their profits are leveraged to the price of oil. When oil rises, their profits tend to move up even faster. Second, they can increase production over time, so they don’t rely on price alone to increase profit.
Legendary investor Warren Buffett’s Berkshire Hathaway has two huge positions in oil, investing in companies rather than the commodity itself.
Potential investments: Chevron (CVX), Valero Energy (VLO), ConocoPhillips (COP), Occidental Petroleum (OXY), Marathon Petroleum (MPC)
Risks: Investing in individual stocks requires significant time and research. You’ll need to find a competitively positioned firm, such as one that has low production costs and a strong record of profitable development. Firms with high production costs may suddenly become much more profitable when oil prices soar, but they also offer plenty of risk if oil prices settle back down.
Individual oil stocks can offer plenty of volatility, meaning you’ll need high risk tolerance to weather any sudden and dramatic declines.
4. Oil Stock ETFs
If you want the attractive returns of stocks without the heavy lifting of research – in short, if you want to play the oil trend – then oil stock ETFs may be the way to go. A sector ETF may hold dozens of oil stocks, helping to reduce your risk while letting you ride oil’s soaring price.
How you can win: An ETF gives you the advantages of oil stocks and their two ways to win: rising oil prices and increased production, but with less risk. Yes, your returns will likely be less than if you had found the best oil stocks, but you’ll raise your overall chances of success and lower your risk, too.
The best oil funds often come with low expense ratios, so you’re not paying a lot for these benefits.
Potential investments: State Street Energy Select Sector SPDR ETF Fund (XLE), Vanguard Energy Index Fund ETF Shares (VDE), State Street SPDR S&P Oil & Gas Exploration & Production ETF Fund (XOP)
Risks: Just like the stocks they hold, these funds can underperform if oil prices sink. And unlike broadly diversified funds such as S&P 500 index funds, a narrowly diversified fund based on one sector won’t protect you against something that affects the whole industry (i.e., falling oil prices).
Also, many funds may have oil in their name. Be sure you’re getting the oil exposure you’re looking for. Exploration and production companies have the most direct upside to rising oil prices. Some funds may have oil equipment companies or refiners that may react differently to oil prices.
5. Oil Stock Mutual Funds
Mutual funds are another way to buy into a diversified portfolio of oil and energy companies, reducing your investment risk but still letting you benefit from rising oil prices.
How you can win: The payoff is similar to that of ETFs. A mutual fund lets you own stocks, which can benefit doubly from oil through rising prices and rising production. So, you’ll get the leveraged return available from an oil producer without the heavy lifting of research and analysis.
Potential investments: Fidelity Select Energy Portfolio (FSENX), Invesco Energy Fund Investor Class (FSTEX), Vanguard Energy Fund (VGENX)
Risks: Like ETFs, oil mutual funds can drop quickly if oil prices plummet. Funds focused closely on oil companies have less diversification than broadly diversified energy funds, but that’s the cost of trying to ride oil prices higher in a focused fund.
With any energy mutual fund, check to make sure you’re getting the exposure you want in the fund. Some funds have stakes in utilities companies or even next-gen (solar and wind) firms.
Is Oil a Good Investment?
Oil and oil stocks can be attractive investments, offering the potential for strong returns:
- Strategically important asset: Oil is a fundamentally strategic commodity, with high energy density that can power a range of devices. It will likely remain an important commodity for many years to come.
- Strong demand: Oil and its derivative products are crucial to the functioning of many machines and processes, meaning sustained demand should keep prices from falling too far.
- Leverage to oil prices: Oil stocks offer leverage to the price of oil, since their profits rise faster than oil itself – one reason Buffett bought oil stocks for Berkshire Hathaway.
- Long-term rising price: Oil’s price continues to rise over time, given its strategic importance and the rising cost of drilling it out of the ground.
- Volatility: The strategic nature of oil and the high inelasticity of demand mean that oil prices can spike on a disruption to supply. That’s an attractive quality for traders.
- Hedge against other investments: An investment in oil can act as a defensive hedge to the rest of your portfolio, helping protect it against the threat of rising prices.
Gold and silver are also popular as defensive investments that tend to rise in tough economic times. Many investors take a small position to help add diversification to a stock-heavy portfolio.
Regards,
James Royal
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