Oil Investing

Updated on April 9, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

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Investment takes place in oil-related assets, commodities, or companies. It is a commodity that is traded globally, due to which it is a desirable investment option. However, investors should consider the risk and return since its price can fluctuate significantly due to many external factors.

Key Takeaways

  • Oil investing involves investing in companies engaged in the exploration, production, refining, or distribution of oil and petroleum products. It can also include investing in oil futures contracts or ETFs that track oil prices.
  • Global supply and demand dynamics, geopolitical events, economic conditions, and government policies influence the price of oil. Understanding these factors is crucial for assessing oil investments’ potential risks and returns.
  • Oil investments offer opportunities for potential profits through price appreciation and dividend payments. However, they also carry inherent risks, including price volatility, regulatory changes, environmental concerns, and technological advancements that may impact the oil demand.

Oil Investing Explained

Oil investing refers to the process of investing funds in various aspects of the oil industry like the assets, company stocks, etc and earn return. This is a very lucrative investment option since this commodity is traded globally. However, along with high return, the possibility of risk is also high.

Investing in oil is a very complex and volatile activity. Although it can be highly rewarding, even giving exponential returns sometimes, the high volatility makes it a game that only knowledgeable and seasoned investors should play. A rookie can lose their money very quickly in this sector.

There are multiple direct as well as indirect ways of investing in oil. Each carries 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.

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Methods Of Brent Oil Investing

There are multiple ways that an investor can take exposure to Brent crude oil investing. The most common methods of investing in oil are listed below-

#1 –  Oil Futures

Like any Futures contract, an oil investing futures contract is an agreement between two parties where the contract buyer agrees to buy a certain quantity of oil at a predetermined oil investing 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 derivative investment product where the underlying asset 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 oil investing 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 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 buy oil company stocks on a stock exchange. This is the most common for retail investors who want to invest smaller amounts of money.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 investment amount keeps increasing, as does the risk and the return potential.

Oil-Investing

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Examples

Let us go through some examples to understand the concept.

Let us assume that Borris is an informed investor who trades using various financial instruments. He predicts that the oil sector has a huge potential to go up in the near future due to expansion in demand and geopolitical factors. Thus, he may go for the following options to earn good return:

Stocks – Borris may identify some good stocks in the oil sector and invest in them. The companies should have a strong babalnce sheet, gloal presence and good future plans.

Exchange Traded Funds(ETFs) – Borris may invest in ETFs in the oil sector having good exposure to production, refining, exploration, etc.

Futures – He may go for an oil investing futures contract. But he needs to monitor the market closely, keep track of the market forces, technical indicators, etc., and make informed decisions.

The above examples clarify how informed investors can decide to invest money in the oil sector.

Benefits

Like any other investment option, this method also has its own advantages and disadvantages. Let us go through the advantages in details as given below:

#1 – Diversification

Brent crude oil investing 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.

#2 – 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 ratio 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.

#3 – 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 reasonable 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 expenses, and legal expenses in the form of cost depletion allowance.

Limitations

Some disadvantages of the process are also highlighted below as follows:

#1 – 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.

#2 – 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.

#3 – 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.

Frequently Asked Questions (FAQs)

1. Are there alternative energy sources that could impact the future of oil investing?

Alternative energy sources can influence the future of oil investing. The rise of renewable energy, such as solar, wind, hydro, and geothermal power, can potentially reduce dependence on fossil fuels, including oil. In addition, increasing investments in alternative energy technologies and government policies promoting clean energy adoption may impact the demand for oil and shift the energy market dynamics.

2. How can geopolitical events impact oil investing?

Geopolitical events can have a significant impact on oil investing. Political tensions, conflicts, or disruptions in major oil-producing regions can lead to supply disruptions and volatility in oil prices. Actions taken by major oil-producing nations, such as production cuts or increases, can also influence market dynamics. 

3. Are there any environmental concerns that could affect the profitability of oil investing in the future?

Environmental concerns can potentially affect the profitability of oil investment in the future. Increasing awareness of climate change and efforts to reduce greenhouse gas emissions have led to environmental regulations and policies targeting the carbon-intensive nature of the oil industry. Stricter emission standards, carbon pricing mechanisms, and global commitments to reduce reliance on fossil fuels may impact the demand for oil and its long-term profitability. 

This has been a guide to what is Oil Investment. We explain its benefits along with methods, examples, and its limitations. You can learn more about excel modeling from the following articles –

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