What is Oil Investing?
Oil Investing refers to the practice of making investments in oil or related sectors by direct or indirect methods of investing in oil. Oil is a highly volatile sector, and it is usually highly knowledgeable or seasoned investors that take exposure in this sector.
Top 4 Methods of Brent Oil Investing
There are multiple ways that an investor can take exposure to brent oil. The most common methods are listed below-
#1 – Oil Futures
Like any Futures contract, an Oil Futures contract is an agreement between two parties where the contract buyer agrees to buy a certain quantity of oil at a pre-determined price at the expiration date from the contract seller. It can be settled physically, that is, by actually delivering the oil at the expiration date and taking the payment as agreed; or, in the case of traders, it can be settled as the difference between the contract price and the market price on the expiration date.
#2 – Oil Options
A brent oil option is a derivativeDerivativeDerivatives 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. investment product where the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. is the oil futures contracts instead of the actual oil. It is the most commonly traded derivative contract in the energy sector. Unlike oil futures, a Long position in an Oil Options Contract gives the person a right, not the obligation, to buy oil in case the market price has gone up higher than the price specified in the options contract.
#3 – Oil ETFs/Mutual Funds
Any fund, or money pool, that invests in the oil sector falls in this category of oil investing. It is the most common among people who want to take exposure to the oil sector, reap the benefits of investing in oil, without having to actually acquire the proper knowledge for it. Oil ETFs/Mutual Funds invest money in companies in the oil sector.
These companies could be involved in the upstream (drilling), downstream (refineries), or midstream (pipelines) category of the oil industry. The United States Oil Fund and the Vanguard Energy ETF are the most common Oil ETFs in the United States.
#4 – Oil Equity
Investors who are avid equity investors and see the oil as an attractive sector take exposure by taking equity positions in oil companies. Now, this can be done in multiple ways. First, an investor can just buy stocks of oil companies on a stock exchange. This is the most common for retail investorsRetail 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. who want to invest smaller amounts of money.
Second, an investor can become a part of a hedge fundHedge FundA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques. or PE fund that provides equity capital to companies engaged in oil exploration or other oil-related activities. Lastly, big corporations invest in oil by establishing facilities for oil exploration/refining activities. With each method, the amount of investment keeps increasing, as does the risk as well as the return potential.
Advantages Of Investing In Oil
- Diversification – Brent Oil is a great way to diversify your investment portfolio. Oil has a low correlation with other prospective assets in your portfolio and can provide the benefit of diversification in a volatile market where some assets would perform well, and some would not. It is also an excellent way to diversify the portfolio for those investors who like to take exposure to different assets and sectors.
- Risk-Reward Ratio – Oil is a highly volatile asset. Only the investors with proper knowledge and understanding should take exposure to this sector. But that being said, oil has a huge risk-reward ratioRisk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process. because the risk it carries is equally high. Suppose if an investor buys land for oil exploration and finds an oil well under that piece of land, the investment can potentially pay off exponentially.
- Tax Benefits There are great tax benefits for investing in oil. If you are an indirect investor, such as you have bought shares of an oil company, you will not see this advantage. But for a direct investor such as a drilling company, the IRS allows the following tax incentives:
- In year one, 60%-80% of good costs are deductible in the form of intangible drilling costs. The remaining amount is depreciated over time.
- Depletion allowance to the extent of 15% of Gross Cash Flow
- 100% deduction of lease expenses, selling expensesSelling ExpensesThe amount of money spent by the sales department on selling a product is referred to as selling expenses. This includes expenses incurred on advertising, distribution and marketing. Because it is indirectly related to the production and delivery of goods and services, it is classified as an indirect cost., and legal expenses in the form of cost depletion allowance.
Disadvantages Of Investing In Brent Oil
- Volatile – Although the risk-reward ratio is typically high for oil, the volatility of this asset is very high. The prices of oil can vary extremely due to multiple factors, with the main being demand and supply. Only the seasoned and knowledgeable investors should take the risk of investing in oil because, without the proper knowledge, you can lose a lot of money very quickly.
- Complex – The world of oil investing is very complex. There are numerous factors that affect this sector, which is why only people with a proper understanding of this market take the risk of investing in this market. There are special tax rules for different countries for oil investment. So understanding this sector is difficult and not for everyone.
- Dry-Hole Drilling – The biggest disadvantage, which can also be related to luck, is the risk of dry-hole drilling. There have been multiple instances where companies buy land and set up drilling operations with huge amounts of investment. But it turns out that the oil well does not exist or has dried up, leading the investment to go to waste.
- Oil Investing is a very complex and volatile activity. Although it can be highly rewarding, even giving exponential returns in some cases, the high volatility makes it a game that only knowledgeable and seasoned investors should play. A rookie can lose his/her money very quickly in this sector.
- There are multiple direct as well as indirect ways of investing in oil. Each caries varied degrees of risk and return potential. The most common method of oil investing for small investors is buying Oil futures and options.
- Big corporations could take exposure to oil by establishing drilling operations (upstream) or setting up refineries(downstream). But the most important thing to keep in mind is that Oil Investing is a very complex activity and should not be done by everybody.
This has been a guide to What is Oil Investment, and it’s definition. Here we discuss the top 4 methods of oil investment along with advantages and disadvantages. You can learn more about excel modeling from the following articles –