With energy prices on a generally upward trajectory, investing in oil seems like a smart move to many. However, as with any investing, there are potential pitfalls that every investor in the commodity should be aware of.
Like any commodity, the price of oil is fundamentally set by supply and demand, although other factors can sometimes greatly influence the price. In recent years, supply as barely kept up with demand at best. In addition, the amount of oil consumed has been greater than new discoveries in most years in the last couple of decades.
All of this, barring an unexpected game changer, points to higher oil prices in the future. On the other hand exactly how much oil is left and whether the world has reached peak oil production is a matter of fierce debate. What is certain is that oil is a finite resource, and even if new discoveries are made, it usually takes a long time to bring the oil to market. However, this does not necessarily make investing in oil a wise move.
Oil is one of the most volatile investments one can make, and prices are affected by a lot more than just supply and demand. When there is not a lot of slack in production, political instability in an oil producing country and quickly push up prices while the calming of political problems will have the opposite effect.
Furthermore, huge sums are invested in oil, and human emotion, combined with speculative fever, can cause significant market fluctuations that have very little to do with fundamentals. In addition to speculators bidding on futures contracts, the money major institutional investors have in oil and other commodities can help bring on big price swings.
Finally, there is the effect of government policy and OPEC. Oil production is heavily influenced by government policies. OPEC strives to keep prices stable, and as high as the market will support, but it often cannot police its members.
Not all oil is created equal
Investors in oil also need to understand that not all oil is created equal. The so called “sweet” high-quality crude, that is easier to refine and often required to meet environmental regulations, if only produced in some countries. Therefore, problems in one place can have a disproportionate effect on prices.
Risk and diversity
All of this means that those investing in oil should be ready for a rough ride. While oil prices are not generally correlated to the price of stock and the US dollar, they often move in the direction of the economy since lower economic activity leads to less demand. However, oil investments can offer diversity to portfolios.
Ways of investing in oil
Few who invest in oil actually directly buy the black stuff. However, there are a number of ways to get in the market.
Stocks: While commodity stocks are often as volatile as the commodities themselves, they offer ways of investing in oil. Investing in companies whose business is oil is close to investing in oil itself. Oil drilling and service companies offer a way to do this.
Mutual funds: A visit to sites such as www.morningstar.com will turn up a lot of the top funds invested in the oil sector and other energy stocks. For those who would like professional management of their investments, these funds are a good choice.
ETFs: Using ETFs to invest in oil as well as many other stock market investments has grown in popularity in recent years. Those unfamiliar with how they work should see what is an ETF, but they are basically funds that are designed to track a certain index. They allow investors a way to diversify since they hold shares in a number of companies. However, they have lower expenses and fees than mutual funds. They can also offer tax advantages since capital gains are usually not taken until they are sold. The relative advantages of mutual funds and ETFs are explained more in ETFs vs. mutual funds.
While ETFs can be used to invest in equity shares in companies, they also offer the ability to invest in futures and derivates for those with the knowledge and money for such markets. ETFs can be purchased both in a single commodity to include oil or multi-commodities in the energy sector.
More on commodity investing can be found in commodity ETF investing. It goes without saying that the volatility of these markets and potential for losses means they only should be approached after careful research. While ETFs can be used to hedge downside risks and other more complicated actions that the average investor does not get involved in, they can certainly be used for more straightforward participation in the markets.
Use sites to include Morningstar to track oil stocks and funds while carefully following oil prices. Those interested in getting into investing in oil should first select the top oil ETFs, stocks or other investments they interested in and see how they respond to market conditions. If willing to go through setbacks and volatility, there are opportunities to make money over time.