How to Invest in Oil
Understand how you can get exposure to the price of oil through CFDs or ETFs in Pakistan. We'll discuss the pros and cons of each approach, and explain how you can get started.
In this article:
CFDs that track the price of oil
Buying a contract for difference (CFD) on the price of oil is perhaps the easiest way to benefit from an increase in oil prices. A CFD is a financial instrument that replicates the price of oil on a one-to-one basis. It's also known as a derivative, because it derives its value from the price of an underlying asset (a barrel of crude oil in this case).
Interestingly, you can also profit from an expected fall in the price of oil by selling a CFD on the price of oil today, even if you don't hold any yet. In the investment world, this is known as "shorting" or "going short". Specifically, you would open a short position today, and buy it back later hopefully at a lower price to close your position and realise your profit.
CFDs are popular with investors because they support leverage. For example, you could open a position in oil up to 100 times greater than your initial investment through a broker like AvaTrade or FxPro. Leverage should be used with caution because it can increase both your gains and losses. That's why we suggest using little to no leverage if you are new to trading.
ETFs that invest in oil futures
You could also invest indirectly in oil by buying shares in an exchange-traded fund (ETF) that invests in oil futures. An oil future is a contract whereby two parties agree to exchange oil on a future date, at a price agreed today. Typically, futures are available for trading several months into the future.
Importantly, there isn't a one-to-one relationship between the price of a barrel of oil today, and the price of a barrel of oil several months into the future. For example, the spot price can exceed future expected prices when demand exceeds supply - the market is said to be in backwardation. Conversely, the spot price can trade below future expected prices when supply exceeds demand - the market is said to be in contango.
Differences between the spot price of oil and future prices will affect your returns in sometimes unexpected ways. When prices are expected to rise (the market is in contango), you will in fact lose money by re-investing your contract into the nearest futures contract, upon expiry. These costs, known as roll costs, arise because the futures contract you own is now worth less than they one you need to buy into. You'll find a detailed explanation about this at the end of this article.
The United States Oil Fund (USO) is the largest oil ETF, with over $3 billion of assets under management. USO tracks the price of U.S. light sweet crude oil, also known as the West Texas Intermediate (WTI). Prior to April 17th 2020, USO was entirely invested in the closest month's futures contact. Following the collapse in spot oil prices, which caused steep contango and high roll costs, USO revised its investment strategy on several occasions. It now invests across a range of upcoming futures contracts. With daily traded averaging 5.2 million contracts on the NYSE Arca, it is highly liquid. It has 0.79% annual management fees.
The Invesco DB Oil Fund (DBO) also tracks the WTI price. However, unlike USO, "DBO since its inception over 10 years ago has always used an optimization process in selecting which futures contract to own," said Bloom, Invesco's director of global macro ETF strategy. When markets are in contango, DBO actively seeks to minimize roll costs. When markets are in backwardation, it looks to maximize the roll yield, by adjusting its roll strategy. DBO's assets under management stand around $500 million, with trading volumes on the NYSE Arca exchange averaging around 819,000 contracts. It has 0.75% annual management fees.
ETFs that invest in oil stocks
If you aren't comfortable with the intricacies of oil futures, you could turn to energy stocks. Unlike oil futures, stocks can fall when interest rates rise. However, they provide three sources of upside that oil futures simply cannot match:
- You'll stand to benefit from increases in the price of oil as well as an increase in demand, as higher prices and production volumes have a multiplier effect on revenues. In contrast, commodity ETFs only stand to benefit from an increase in prices, which may be tempered by roll costs.
- Because companies have fixed costs (in the form of general, administrative expenses and financing costs), an increase in revenue can lead to an even greater increase in earnings per share. This concept, known as operating leverage, can be a powerful way to profit from a surge in oil prices.
- Last but not least, energy companies may also buy-back stock at times when they are generating large amounts of free cash flow. Share buy-backs mechanically increase earnings per share, which also supports share prices.
However, investing in individual equities isn't without its risks. You could lose the whole of your investment in the event of bankruptcy. That's why we like the idea of investing in an ETF, which holds stakes in a large number of companies, in order to diversify risk and get broad exposure to the energy sector.
The Energy Select Sector SPDR Fund (XLE) is the largest energy ETF with over $18 billion assets under management. It seeks to replicate the price performance of the S&P's Energy Select Sector Index. This ETF holds positions in 27 companies engaged in the oil, gas and consumable fuel, energy equipment and services industries. Together, Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) account for 44% of its assets. XLE has a 0.12% expense ratio.
The Direxion Daily S&P Oil & Gas Exploration & Production Bull 2x Shares ETF (GUSH) is focused on companies engaged in oil & gas exploration & production, a narrower segment than XLE. It is a leveraged ETF, which seeks daily investment results of 200%, or 200% of the inverse (or opposite), of the performance of the S&P Oil & Gas Exploration & Production Select Industry Index. Leveraged ETFs are best suited to investors with short investment horizons, such as day traders, because leverage can compound gains and losses in unexpected ways. If you are new to leveraged ETFs, this article explaining the risks of leveraged ETFs for buy-and-hold investors will be of interest.
The VanEck Vectors Oil Services ETF (OIH) seeks to track the price performance of 26 U.S. listed companies involved in oilfield services (OFS) to the upstream oil sector. The OFS sector is particularly cyclical, as demand for its services depends on consistently elevated oil prices. Schlumberger NV (SLB) and Halliburton Company (HAL) account for 31% of its assets. This ETF has a 0.35% expense ratio.
The weird and wonderful world of oil futures
If you aren't familiar with the concepts of contango and backwardation, investing in oil futures may not be right for you. A sharp rise in the price of oil could lead to a fall in your ETF's net asset value. Before we touch on these concepts, it helps to understand how futures contracts work.
Unlike gold ETFs, which hold physical gold reserves, oil ETFs buy and sell oil futures rather than physical barrels of oil. A oil future is an agreement to buy a given quantity of oil for a set price, at a future date. The price of a future changes over time, but trends towards the current price (also known as spot price) upon expiry.
Upon expiry, the holder of a future must take physical delivery of the barrels. This can be costly as the buyer needs to cover storage and delivery costs. That's why most traders sell their future at least one day prior to expiry, and re-invest the proceeds into a longer dated futures contract. This process is known as the roll, or rolling over.
The market is said to be in contango when the spot price is lower than the future prices. This can occur because of the storage, financing and insurance costs associated with taking physical delivery. It can also occur for fundamental reasons when traders expect oil prices to rise in the future. Backwardation occurs when the spot price is higher than the futures price. Backwardation and contango can affect an ETF's returns in surprising and unexpected ways.
When you invest in a futures-backed ETF, your return will depend on the following four factors: 1) the spot price, 2) the roll cost or yield (which can affect your total return in unexpected ways), 3) interest income, and 4) the fund's expense ratio.
- Spot price: you stand to benefit from an increase in prices. If prices rise from $100 to $101/barrel, you will lock-in a $1 profit.
- Roll cost or yield: an ETF that invests only in a commodity's front-month futures contract stands to lose if the market is a contango (aka. prices rise). Let's assume that an ETF holds the front-month WTI contract worth $100/barrel. If the second-month futures contract trades for $101, the ETF will lose $1/barrel upon rolling over as it will sell for $100 and buy for $101. Roll costs will eat into your returns. Conversely, you could benefit from a roll yield when markets are in backwardation.
- Interest income: futures-backed ETFs only need to put down a fraction of a contract's value as collateral. They typically invest remaining funds in short term securities, such as Treasuries. These returns are negligeable when interest rates are low, as is the case today. However, interest income provided investors with sizeable returns in the 1980s when interest rates were in the double digits.
- Expense ratio: finally a fund's expenses will eat into your returns. The amount, expressed in percentage terms, is deducted on a daily basis from the ETF's net asset value. The average ETF carries an expense ratio of 0.44%, which means the means will cost you $0.44 for every $1,000 that you invest.