Oil is an investment that has captured American’s attention since the drilling of the first well in 1859 along the Oil Creek in Pennsylvania. Since then, oil has had a volatile history that has made fortunes and brought countries to a halt.
Oil falls into the family of commodities as an investment. A commodity is an economic good or service that is interchangeable with other commodities of the same type. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. The demand and price for a commodity are very close to being the same across all markets. For example, oil is oil, no matter where the well is. While there are different grades of oil, the same grades are almost identical wherever they come out of the ground. This differs from something manufactured, like a laptop. Such a product varies from one company to another and has so many different design possibilities that they all have different prices.
Investors can directly invest in oil as a commodity. There are several ways to approach this. One simple way for the average person to invest in oil is through stocks of oil drilling and service companies. Another 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.
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 mostly 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. They can serve as a hedge and as a way to diversify your portfolio.
The oil market is confusing to both the professional and average investor alike. There are significant price swings…sometimes daily. It is an industry that is continuously evolving and changing. If you look at simple supply and demand, you can see one reason prices seesaw radically. Countries like the United States have decreased their need for oil. Even with emerging economies having an increased requirement for it, the overall drop in demand lowers prices.
The supply side of oil used to be closely monitored by OPEC. This consortium of oil-producing countries banded together to regulate how much oil they pumped out and sold to the world. As other sources of oil outside of the OPEC nations became available, their power and influence dropped with plummeting oil prices. As the alliance weakened, certain countries like Saudi Arabia pumped out more oil to try and keep their income the same with the lower price per barrel. This further increased the supply of oil and contributed to even lower prices.
We have recently witnessed a price war between Saudi Arabia and Russia. While this was great for people who buy gas for their car, it set the oil market into chaos. The price for a barrel of oil was lower than it had been in decades. It was almost a war of attrition until cooler heads prevailed, and an agreement was reached between the two countries to stabilize prices. On the heels of that, Coronavirus hit, and people weren’t driving, flying, or cruising. The glut of oil on the market got to be so much that the United States ran out of places to store the excess.
You can see the volatility of oil in the United States over the last decade. When fracking became an economical method for extracting oil from shale, areas of the country boomed with renewed fiscal vigor as the oil industry expanded to areas never used for oil production before. Towns sprang up around these areas with a call for workers to travel to places like Texas or North Dakota. The amount of oil surged as did profits. A few short years later, the areas are ghost towns, and wells were closed as the price of oil dropped and made those operations cost-prohibitive. They could very well open again when the price of oil goes up.
The oil industry is also affected by the political winds of the world. Whether it be the threat of war or some other major upheaval, the price of oil goes up. If war threatens an oil-producing nation, it goes up that much higher. The joke is that if a camel sneezes wrong in the Mideast, oil goes up!
When entering oil as an investment, scrutinize your options. Yes, money has been made with oil in the past and will in the future. Carefully decide how it will be a part of your overall investment strategy if you want oil in your portfolio.