How to Invest in Oil

Investors have many ways to bet on the direction of crude oil prices. The alternatives range from crude oil futures and options to exchange-traded derivatives, energy equities and sector mutual funds. Each of these choices has particular risks, and all of them involve exposure to one of the world's most volatile commodities. All can be purchased through an online brokerage account or a full-service broker.

Oil as an Asset

Oil is an economically crucial resource, providing the bulk of energy for transportation as well as raw materials for manufacturing. It is the world's most heavily traded commodity. Because crude oil is so essential and the process of producing it is lengthy, consumers as well as suppliers are notoriously slow to adjust consumption and production as prices rise or fall. That means oil prices must move further to rebalance markets in the wake of disruptions such as a drop in demand caused by a pandemic or an interruption of supply stemming from war or economic sanctions.

Oil prices are set globally in a variety of spot and futures markets for crude as well as related products by market participants including producers, consumers, short-term speculators and longer-term investors.

While energy prices tend to be volatile, the markets setting them are highly liquid and market participants typically well-informed. Traders without extensive expertise should proceed cautiously.

Oil Futures, Options and Spot Markets

You could buy crude outright in the spot market, if you had deep pockets and sufficient storage facilities to accommodate a shipment of 600,000 barrels from a tanker or even 25,000 barrels a month via pipeline.

For most, crude oil futures or options on oil futures will be the more realistic alternative. On the CME Globex futures exchange, a single crude contract represents 1,000 barrels. To trade futures through an online brokerage account you will need to obtain margin and pass a broker's suitability review, not a particularly tough task these days.

The process typically requires completing an online application and waiting a few days. Some brokerages require a minimum account value to authorize futures trading, while others do not. Fees and commissions will also vary.

Alternatively, you could trade futures with the aid of a full-service broker, typically a commodity trading advisor (CTA).

Some crude oil futures contracts use cash settlement at expiration while others require the transfer of crude at a pre-specified delivery point.

Crude oil producers and consumers use futures to hedge production revenue and energy costs respectively. Speculators trying to profit from short-term price changes are less likely to take delivery of the underlying commodity at a future contract's expiration.

In April 2020 the price of the expiring May West Texas Intermediate crude oil futures fell to -$37 per barrel shortly before expiration, meaning traders were willing to pay to avoid having to take delivery of crude with storage facilities full in the early stages of the COVID-19 pandemic.

Commodity ETFs and ETNs

In recent years, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) have sprung up to offer crude oil exposure for retail investors not able or willing to trade commodity futures.

Crude oil ETFs invest in crude oil futures themselves in an attempt to track the performance of the underlying commodity index. Because crude oil futures are often in contango, commodity ETFs like the United States Oil Fund (USO) must often to pay up to roll expiring futures contracts into the next month, introducing one potential source of tracking error.

USO's investment objective is to provide average daily return within 10% of the average daily return of the front-month contract for West Texas Intermediate crude oil over any 30-day period. In 2020, oil market dislocations and position limits imposed by future exchanges as well as the fund's futures broker effectively blocked the fund from deploying investment inflows into front-month crude oil futures for a time. While the fund has continued to meet its investment objective by investing in longer-dated oil futures as well as the front-month contract, it acknowledges increased uncertainty about its ability to stay within the specified tracking error limit in the future.

In November 2021, USO agreed to pay a combined $2.5 million in penalties to the U.S. Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to settle allegations it failed to disclose in a timely manner the position limits imposed by its broker.

Because commodity ETFs frequently suffer from negative roll yield as futures contracts expire, they're suitable for short-term speculation only. With oil prices at seven-year highs above $100 per barrel in March 2022, the USO's price was down nearly 90% since launch in 2006 as of March 1, 2022. As of the same date, USO's sister fund investing in crude oil futures expiring over the next year, the United States 12 Month Oil Fund (USL), was down 44% since inception in 2007.

The Invesco DB Oil Fund (DBO) is another commodity ETF. It invests in crude oil futures up to 13 months out based on a methodology seeking to minimize negative roll yields and maximize positive ones. DBO, which had market value of $506.7 million compared with USO's $2.9 billion as of March 1, 2022, had returned a cumulative -2.6% since launch in 2007.

In contrast with commodity ETFs, commodity ETNs including iPath Series B S&P GSCI Crude Oil Total Return Index ETN (OIL) and Credit Suisse X-Links Crude Oil Shares Covered Call ETN (USOI) represent contracts between investors and the issuer. The issuer will very likely use crude oil futures contracts to offset its exposure, but the ETN itself holds no assets. ETN returns are not subject to tracking error, but pose counterparty risk, because they are unsecured debt obligations.

Another advantage of commodity ETNs is that capital gains taxes are deferred until the position is sold, while gains on commodity ETFs are taxed annually even if they remain in the portfolio.

Commodity ETFs as well as ETNs may allow the issuer to redeem them under certain circumstances.

Energy Stocks, Equity ETFs and Mutual Funds

Investors can also gain exposure to oil by purchasing related equities directly, or through energy-sector ETFs and mutual funds. While energy stocks come with their own risks, ETFs and mutual funds offer diversification within the sector.

The Energy Select Sector SPDR Fund (XLE) is a leading energy ETF representing energy stocks in the S&P 500 index, a large-cap benchmark. With a market value of more than $36 billion as of March 1, 2022, XLE includes the largest integrated oil companies in the U.S. As of the same date, Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) together accounted for more than 44% of XLE's portfolio.

The iShares Global Energy ETF (IXC) provides exposure to the largest energy companies globally. Exxon and Chevron accounted for about 26% of the $2 billion fund's portfolio in March 2022, followed among top holdings by Shell Plc. (SHEL), ConocoPhillips (COP), TotalEnergies (TTE), BP Plc (BP), and Enbridge Inc. (ENB).

ETFs, including the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), the iShares Dow Jones U.S. Oil & Gas Exploration & Production Index Fund (IEO), and the Invesco Dynamic Energy Exploration & Production Portfolio (PXE), focus on upstream U.S. oil and gas producers. XOP is the only one of the three to exclude crude refiners.

U.S. and overseas crude refiners are the sole focus of the VanEck Vectors Oil Refiners ETF (CRAK). The VanEck Vectors Oil Services ETF (OIH) represents oilfield services and drilling rig providers, with Schlumberger NV (SLB), Halliburton Company (HAL), and Baker Hughes Company (BKR) accounting for 39% of the portfolio in the aggregate.

The JP Morgan Alerian MLP Index ETN (AMJ) is an exchange-traded note representing the largest U.S. energy pipeline operators, sometimes also called the midstream sector. The ETRACS Alerian Midstream Energy Index ETN (AMNA), sponsored by UBS (UBS), is a similar offering. Because the midstream sector includes master limited partnerships, midstream ETFs (as opposed to ETNs) tend to lag in performance because they cannot take advantage of certain MLP tax benefits.

The Vanguard Energy Fund Investor Shares (VGENX) and Fidelity Select Energy (FSENX) are among the largest mutual funds focused on energy.