Though there is evidence that oil had been used for medicinal purposes since the early 1400’s, the first commercial well was not drilled until 1859 when oil was struck in North Pennsylvania, USA. The Drake Well at Titusville was able to produce around 20 barrels of oil a day, and kick started an industry that is now worth trillions of dollars. Three of the world’s largest ten companies by market capitalization are oil companies, with two others narrowly missing inclusion.  Because of its size and importance to the world economy, the oil sector is one which general portfolio managers and individual investors should not ignore. There are several ways to invest in oil, but before we look at these, here are a few reasons why investment in the so-called ‘black gold’ represents good value over the long term.

Oil is a Finite Resource

Though now produced in millions of barrels per day, it is widely understood that oil, as a natural resource, is in finite supply. At some time, oil production will dry up. This is one reason why so many existing and new energy companies are seeking alternative energy supplies and methods. Of course, new oil fields are being discovered, and current oil fields drilled more deeply, as demand for oil grows and makes these more expensive oil discoveries financially viable. As the oil price increases, more expensive oil production becomes worthwhile to oil explorers and producers. In this way, the oil price is like a self-regulating tap: if it is economically sensible to do so, oil companies will drill for oil and increase supply. If it isn’t, they won’t, and if they don’t supply will fall and the price of oil will rise.

Demand Keeps Growing For Oil

At the start of the 20^th century, the world population was estimated at a little over 1 billion. It now stands at over 7 billion. These extra mouths energy to keep warm in the winter and cool in the summer. They need energy to help cultivate and harvest crops for food, and then to transport food, goods, and services. On top of this, many Asian countries are undergoing industrial expansion similar to that seen in the west during the industrial revolution. China and India, with nearly a third of the world’s population between them are seeing rapid growth in their industrial bases. Oil is needed for fuel, heating, and transportation, as well as being used directly in many manufacturing processes.

Geopolitics

Political turmoil around the world, particularly in the Middle East, will raise oil prices. This rise in prices makes other oil discoveries financially viable to extract. Even in times of relative political harmony, oil prices have risen due to demand, economic growth, or the maintenance of levels of supply.

Another quality of oil from an investment viewpoint is that, unlike gold or cash, for example, it cannot be confiscated or destroyed at will by extremist governments. Though such governments can cut off supply to the outside world, they often rely on oil revenue to support their spending and more targeted sanctions are often enforced for limited periods of time.

Oil Is An Excellent Hedge Against Inflation

Oil is a large component of the inflation index. As such, investment in oil provides an excellent defensive quality to a portfolio in times of rising inflation. It is also a commodity that remains in demand even during marked economic downturns, recessions, or depressions. People will always need to heat food, heat themselves, and transport goods and services.  Until there is another form of energy as reliable and plentiful, oil will be the boss.

Oil is still the Number One Supply of Energy

Though alternative forms of energy are being developed – wind and solar power, for example – oil is still the most efficient form of energy known to man, excluding, perhaps, nuclear energy. The 2011 tsunami in Japan, and subsequent problems with its Fukushima nuclear power plant helped to highlight the risk with nuclear energy. Electricity is produced more cleanly with oil than coal, and initial cost is an almost insurmountable barrier when discussing alternative energy sources.

Ways to Invest in Oil

Barrels

An investor could buy barrels of oil and store in a large barn or shed! More seriously, direct investment into oil wells or ‘ground floor’ exploration companies can produce stunning returns. However, investment in such private enterprises entails the risk that oil finds will be lower than expected, or perhaps not forthcoming. For the higher potential rewards, investors take far higher risk.

Shares Of Stock

An investor is able to purchase shares of either upstream (exploration and production), downstream (marketing and sales) or diversified oil companies easily on multiple stock market exchanges. Though this gives an indirect exposure to the oil price, in most cases such companies offer diversification not found in small start ups: if one oil field fails, there will be others that succeed. Shares of oil companies are also affected by general market sentiment, internal costs of production and distribution, and will not be a sole reflection of the prevailing oil price.

Exchange Traded Funds

Exchange traded funds (ETFs) trade on stock exchanges, very much like stocks, and hold quantities of its underlying assets (or derivative products that give it exposure to those assets) to satisfy the ownership of the ETF. They have low dealing costs, are tax efficient for many investors, and trade at near their net asset value, and can also be used by bullish and bearish investors.

Oil ETFs are a simple and fast solution for an investor who wants immediate exposure to the oil sector.

The most actively traded Oil ETF in the United States is the United States Oil Fund (NYSE: USO) which aims to track the performance of the spot price of West Texas Intermediate light crude. It invests in the futures of West Texas Intermediate light.

Futures

An Oil Future is a contract that gives the holder the obligation to buy a pre-determined amount of oil at a pre-determined price, and on a pre-determined date in the future. Oil futures can be bought and sold on the futures markets, one of the largest of which is NYMEX, through a broker or an on line trading account. They give excellent exposure to the oil price, though the market can move very fast.

Futures also give you the opportunity to put on positions known as spreads, which are popular among professional traders.  In the oil complex, the most popular spread is the crack spread, which involves buying oil futures contracts and selling contracts in heating oil and gasoline, which are products that are “cracked” from oil. Spreads tend to hedge risk, but you can still lose money and history has shown that these spreads can also be volatile.  When futures contracts increase in volatility, the exchange will usually raise the margin requirements as well.  This should all be taken into consideration when determining if trading futures is right for your business.

Options

Options are available for crude oil futures, its derivatives, as well as ETFs and stocks.  Options are contracts that give buyers certain rights, and sellers certain obligations.  Leverage can be high, but options offer a wonderful opportunity to not only take advantage of directional movement, but also allow the astute investor a chance to profit if there is very little movement.

Spread Betting

For those living outside of the United States, on line spread betting companies offer investors, or more usually day traders, a cheap and efficient way to gain direct exposure to the spot price of oil. However, many of the spread betting contracts are on a ‘win or lose’ basis. In other words, if the price of oil does not behave the way the trader expects it to – and has ‘bet’ that it would – the bet is lost, and the trader will have lost the original capital laid. Spread betting is fast, cheap, and efficient, with potentially high rewards, equally high potential losses.

Investment and Taxation

Whatever an investor’s preferred method of investing, his returns will be affected by the tax suffered on any gross profits made. These taxes include capital gains taxes on profits, and income taxes on dividend income, and vary from country to country. An investor should always be aware of potential tax liabilities.

In Conclusion

Oil is a depleting resource that is likely to see strong and growing demand in the future. There are several ways for investors to gain exposure to the price of oil, whether the investor is bullish or bearish. Detailed consideration should always be given to risk and the potential consequences thereof before making any investment decision.

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