What Is Oil ETF?
Oil ETF is the exchange-traded funds which invests in the firms operating across commodities in the oil and gas industry. It tracks a particular segment of the market and comes up with a unique proposition that allows investors to take positions without worrying much about the threshold or margin requirements and trade very much like they do inequities.
Given its size and importance in the global economic and political scenario, the oil industry is the darling of investors and traders. Consequently, the corresponding contracts are equally popular but riskier because of the very nature of the derivative markets. However, using oil ETF, one can understand and take positions in the oil commodity and reap profits.
- The “oil ETF” invests in companies that deal in oil and gas-related commodities.
- It tracks a specific market segment and offers investors a unique opportunity to take positions without worrying too much about threshold or margin requirements. It trades very similarly to how they would with stocks.
- Investors keep a watch on crude oil and the derivatives contracts related to it. Since this commodity is so popular, even the five- and ten-year contracts are active and very volatile.
- Because of the rewards it provides, the erratic oil business is highly well-liked by investors.
Oil ETF Explained
Oil ETF is a kind of investment in which the investors can gain exposure to the performance of the oil industry either through derivatives like future contracts and options or by investing in shares of companies in the oil industry.
Oil ETF stock invests in companies across oil and gas commodities through commodity pools with limited partnershipsLimited PartnershipsIn a limited partnership, two or more individuals form an entity to undertake business activities and share profits. At least one person acts as a general partner against one limited partner who will have limited liability enjoying the benefits of less stringent tax laws. through both derivative contracts such as futures and options and shares of the firms dealing in these commodities.
It works as a proxy for investors who want to participate in oil traded firms and reap potential benefits. These investors can only focus on the oil index without worrying about operational issues like logistics, delivery, storage, etc.
The volatile industry of oil is quite popular among investors because of the returns that it offers. It offers huge returns, but with huge returns, the huge risk is involved. The prices of oil contracts move up and down in a very short span of time. This is because the underlying commodity – oil, is highly volatile and is affected to a huge extent by the global political conditions. If the global economic growth and political conditions are stable, oil prices would be stable.
Following are some examples of top traded oil ETF stock in international markets:
#1 – XLE
- Full Name – Energy select sector SPDR
- Assets Under Management – $ 13 Billion
- Expense Ratio – 0.14%
- Performance – 21.47% (1-year return as per 2015 stats)
#2 – CRAK
- Full Name – Vleck vectors Oil refiners ETF
- Assets Under Management – $ 24.82 million
- Expense Ratio – 0.59%
- Performance – 36.57% (1-year return as per 2018)
#3 – USO
- Full Name – United states Oil fund
- Assets Under Management – $ 3.95 billion
- Expense Ratio – 0.72%
- Performance – 45.97% (1-year return as per 2018)
The gas and oil ETF is not very different from mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc with the only difference that they can trade at an exchange in real-time much like shares. Mutual funds, on the other hand, are valued based on the final settlement price at the end of the day. Also, there is no minimum threshold, and even retail investors can sell an oil ETFETFAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange. with small amounts. There are four main types of Oil ETF:
#1 – Leveraged Oil ETF
Leveraged gas and oil ETF focuses on the amplified returns compared to the benchmark index while maintaining the minimum losses. For example, a double ETF focuses on getting the double returns to the movement in the benchmark index.
#2 – Inverse Oil ETF
Inverse oil ETF price focuses on getting returns if the oil prices move in the opposite direction. For example, if the oil prices dropped by 7%, such would be the composition of the index that the returns would be approx. 7%. Because of this, most often than not, the inverse oil ETF is the best hedging mechanism among the available Oil ETF options.
#3 – Smart Beta Oil ETF
Smart Beta Oil ETF does not have a specified strategy, but these funds focus on maximizing returns based on smart, unconventional strategies and tactics. They are very risky but equally rewarding.
#4 – Index ETF
Last but not least is the index ETFs. These are the vanilla products that try to mirror the basket of different varying products.
Some of the advantages of this kind of ETFs are as follows:
- Investors always an eye for crude oil and its derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. contracts. In fact, such is the penchant for this commodity that even the five year and 10-year contracts are liquid and highly volatile. Unlike bitcoinBitcoinBitcoin is a digital currency that came into existence in January 2009, speculated to be created by Satoshi Nakamato, whose true identity is yet to be authenticated. It provides lower transaction fees than the traditional online payment systems, is controlled by the decentralized authority, and is not like government-issued currencies. or cryptocurrenciesCryptocurrenciesCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service., it is not one of those assets which have been conceptualized only on paper where valuations are defined based on the euphoria created by the speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return. with fundamentals being left behind.
- Oil, on the other hand, is one of the richest industries of the last century. In fact, it is the backbone of other major capital-intensive industries like airlines, auto majors, and to some extent, fast-moving consumer goods. As per independent research in 2018, the oil industry size was estimated at 2.5 trillion $.
- In fact, the expenditure on this industry by consumers is much more than other commodities like iron, gold, silver, etc. however, because of the huge volatility involved, many retail investors are not able to participate in this industry and are forced to be away from this unpredictable but fundamentally sound commodity marketCommodity MarketThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities..
- It helps those investors in investing as a basket without worrying about the multiple industries which might be located very far geographically and thus eliminating country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place..
- Dealing in oil ETF price provides the best hedge for the retail investorsThe Best Hedge For The Retail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making. as well as for the firms that already have oil positions. Consider the example of the aviation industry that unknowingly has huge exposure to oil contracts because of the very industry they worked on fuels on this energy source. It helps these firms in hedging their naked positions and making sure the profitability is intact.
Let us look at some of the disadvantages of the ETF alongside its benefits.
- If there is a global turmoil or a war-like situation or a political crisis, oil prices are impacted hugely, and conversely, the oil contracts rise or fall multi-folds. Also, oil prices are impacted even when there are talks about recession as the receding economy requires less oil, which is again a concern for the investors and affects the oil prices, thereby oil contracts. To cut the story short, trading in oil requires a good amount of volatility, which everyone cannot digest. However, trading in Oil ETF helps investors in taking positions without worrying much about volatility.
- Any kind of political instability in the areas where oil production takes place will affect the oil prices and in turn have an effect on the ETFs. Problems like sanctions, wars or any type of natural disasters will negatively impact the demand and the supply of oil and consequently affect the ETFs.
• The management fee charged by the ETFs can reduce the returns on them. In case the investors invest on a long term basis, then over time the returns might reduce substantially.
• Investors may be concerned about the effect on the environment because investment in the oil industry means higher production of oil which is a fossil fuel and is non- renewable. Thus, over production will deplete them faster and also lead to a negative effect on the climate. So there is an ethical concern in this field also.
• There may be a contango effect on this type of ETFs leading to a decrease in value of the same. Contango is the situation in which the price of futures of the commodity is more than the spot price. Thus, the ETF’s value comes down.
How To Buy?
Now let us try to understand the various steps that are to be followed in order to invest in the best oil ETF.
• Good Research – Proper research and clear information is always helpful before any kind of investment. Therefore the investor should do a through research, find out the performance fees to be charged and compare them with their peers, and also look for the strategies that will be used. This will help in selecting an ETF that aligns with the risk tolerance of the investor and their aim of investment.
• Place the trade – next comes the step of placing the trade which will happen only after identifying the correct ETF for investment. The investor will place a buy order form the brokerage account and specify the number of stocks that they want to invest in along with the price.
• Investment monitoring – It is very important to keep track of the ETF’s performance regularly. This can be done by tracking the performance of the oil industry, the economic and political conditions of the country, etc.
- Brokerage account – It is necessary to have a brokerage account to buy it. It is always better to select a brokerage that offers ETFs commission free or allows trading an a minimum fee so that the investment cost is reduced.
Thus, the steps of investing in the best oil ETF are given in detail above. However, since risk is involved in the entire process, it is always recommended that the investor take the help of a financial advisor to understand whether the selected ETF aligns with their profileand then go ahead with the investment.
Frequently Asked Questions (FAQs)
Whether oil ETFs are a good buy depends on various factors, including your investment goals, risk tolerance, and the outlook for the oil market. It is essential to conduct thorough research, analyze the current oil market conditions, and consider your investment needs before deciding.
Oil ETFs typically do not pay dividends in the same way as individual stocks. Unlike stocks of respective companies that may distribute dividends to shareholders, most oil ETFs are structured to reflect the performance of the underlying assets they track, such as oil futures contracts or energy company stocks. However, there are a few exceptions where certain oil ETFs may distribute dividends.
Oil ETFs aim to mirror the performance of the underlying assets they track. They can be structured as commodity ETFs, equity ETFs, or a combination. Investors can buy and sell shares of the ETF on stock exchanges like regular stocks.
This has been a guide to what is Oil ETF. We explain how to buy it along with examples, types, advantages and disadvantages. You can learn more about investment from the following articles –