How to invest in oil

Oil is a basic necessity of modern life, and it’s among the most strategic commodities. So it’s not surprising that oil is a popular investment, and while green energy has become a growing force recently, modern economies will need oil for a long time, putting a floor under its price.

So oil offers the kind of safe-haven potential that investors in gold like, and it also provides a means to hedge an investment portfolio, too. By investing in oil, advanced investors can offset a rising oil price on the rest of their portfolio, protecting against the often-volatile pricing of this key input.

Here are five different ways to invest in oil, from direct ways to the more indirect.

5 ways to invest in oil

1. Oil ETFs

One of the easiest ways to invest in oil is via an oil exchange-traded fund (ETF). An oil ETF owns futures and options contracts on crude oil, rather than the commodity itself — unlike some gold ETFs that own the actual physical metal. As the spot price of oil fluctuates, the price of the ETF will tend to mimic these changes, though imperfectly due to how the fund invests in oil.

So if you think the price of oil will rise and don’t want the hassle of managing futures and other contracts yourself, an oil ETF may be the way to go. Of course, by betting on the price of oil with a fund, you have only one way to win: if the price of crude rises. While that’s been a good bet over the long term, this kind of ETF may be better as a trading vehicle than a buy-and-hold investment.

Three of the largest ETFs include United States Oil Fund (USO), Invesco DB Oil Fund (DBO) and ProShares K-1 Free Crude Oil Strategy ETF (OILK).

Risks: The price of oil can be volatile, which is perhaps the most obvious risk of investing in oil. Given this historic volatility, an oil ETF may be a better pick if you’re looking to trade the market over a shorter time frame — say, when the economy is on the upswing. And since oil funds don’t own oil directly, their performance may not track the price of oil all that well.

2. Oil futures

Looking to take oil trading into your own hands? You can invest in oil derivatives called futures, essentially doing for yourself what the oil ETFs charge you for. Futures are the most popular way to trade commodities such as oil, gold, corn, wheat and a range of other agricultural goods.

With futures contracts, you agree to purchase oil at some specified price in the future, and you need to put up only a portion of the contract’s value now. Because of this structure, futures let traders buy much more than they would otherwise be able, and if things go well, they can earn a lot of money. But they can lose it just as quickly if the commodity’s price moves the wrong way.

You’ll need to work with a broker that offers futures trading, which typically requires a higher account minimum than a traditional stock brokerage account.

Risks: Because of the leverage involved in futures and the volatile nature of oil, you can win and lose quickly. If oil moves against you, you’ll need to put more cash to hold your futures position or otherwise have it closed out — perhaps just when it’s lowest. Futures are for experienced traders, and only some of the top brokers offer the ability to trade futures contracts.

3. Oil stocks

Another way to invest in oil is to own the businesses that produce it, and oil exploration and production (E&P) companies can offer you multiple ways to win when oil rises. This path may be the best option for investors, because they can profit when oil rises but also when the company increases oil production, so they’re not just stuck relying on the oil price alone.

In addition, as the price of oil increases, each barrel that’s produced becomes incrementally more profitable for the oil company. So its profits can rise faster than the price of oil itself.

Risks: Investing in individual stocks requires a lot of time and energy, and you can’t just throw a dart and expect to be successful here. You’ll need to invest in a well-positioned company if you want to increase your odds of success and stick with a proven player, not a company that’s in the development stage or still looking for its first well. And of course, individual stocks can be every bit as volatile as the price of oil, so you can still be in for a bumpy ride.

4. Oil stock ETFs

If you don’t want to invest in individual oil stocks, then you can purchase an ETF that holds oil companies. You’ll still get exposure to oil but in a more diversified way that reduces your risk. The fund may hold dozens of oil stocks, reducing your reliance on any one of them too much.

Three of the largest funds include Energy Select Sector SPDR Fund (XLE), Vanguard Energy ETF (VDE) and SPDR S&P Oil & Gas Exploration & Production ETF (XOP). They all feature low expense ratios — just 0.09 percent, 0.10 percent and 0.35 percent, respectively — so you won’t end up paying a lot to own the fund and for the advantages of diversification.

Risks: A fund’s diversification can protect you against the issues plaguing a specific company, but it won’t protect you if something affects the entire industry, such as a sustained decline in the price of oil. You’ll want to carefully look at what’s included in your fund and whether you’re getting the kind of investing exposure you want, because ETFs may have non-oil companies in them.

5. Oil stock mutual funds

Oil stock mutual funds offer another avenue to invest in a diversified collection of oil companies that reduces your risk but still gives you upside if the price of oil moves higher.

Two of the largest funds here include the Vanguard Energy Fund (VGENX), with an expense ratio of 0.44 percent, and Fidelity Select Energy Portfolio (FSENX), with an expense ratio of 0.73 percent. These funds have heavy exposure to oil producers but also contain other businesses that have less upside if oil rises, as well as other related companies like coal or solar producers.

Risks: Like oil ETFs, a mutual fund’s diversification protects you against the challenges individual companies face but not against something that affects the industry as a whole, such as falling oil prices. Also like ETFs, mutual funds may contain many companies that don’t give you the exposure to oil prices that you want, so it’s important to look at the fund’s holdings.

What makes oil an attractive investment for many investors

Oil offers a lot of positive qualities that can make it an attractive investment.

• Strategically important commodity: Oil is a strategic commodity, and while other competing energy sources are coming on line, it will remain vital for the foreseeable future.
• Strong demand: The variety of uses for oil and its derivative products means that demand will remain high and will help keep a floor under the commodity’s price.
• Long-term rising price: Closely related to strong demand, the price of oil has increased over the long term, making it attractive to continue drilling and producing oil.
• Volatility: Volatility is an attractive quality for traders looking to make money on the short-term swings in the price of oil.
• Defensive store of value: Given the strong demand for and strategic necessity of oil, the commodity can act as a store of value over longer periods.
• Hedge against other investments: Many companies rely to some degree on affordable oil, so when oil rises, they can get hit. An investment in oil can be used as a hedge against increasing oil prices in the rest of your portfolio, helping reduce the risk of rising oil.

Other commodities like gold and silver have proven to be trading alternatives.

Bottom line

Investors have a variety of ways to play the price of oil depending on exactly the kind of upside and downside they want. Investing in an oil fund or oil futures may offer plenty of attractive volatility for traders, while individual oil stocks may offer more long-term upside for investors.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.