🛢️ Your Guide To Investing In Crude Oil, AKA Liquid Gold
Crude oil is basically liquid gold. Sort of. It’s the refining process that produces a range of valuable liquids, some of which are then further processed to make a lot of the consumer products we all use everyday. So no, it’s not just fuel for vehicles and planes. It’s used to generate electricity, and is in everyday items like cosmetics, crayons, kitchen supplies, plastics, textiles (acrylic, nylon, etc.), electronics, medicines, the list keeps going, you get the point. It also takes millions of years to form, making it an inefficient & nonrenewable commodity that releases gases that stays in our atmosphere when burned, acting like a blanket and keeping the heat from the sun. Until we develop affordable & viable alternatives, crude oil is here to stay.
The Different Types Of Oil
There are actually more than 160 different types of crude oil on the market, each of which differ in terms of how “sweet” or “sour” it is (the sulphur content) & how “heavy” or “light” it is (viscosity). The most important ones that’s used as pricing benchmarks (a reference price for buyers & sellers) for their respective regions are:
🇬🇧🛢️ Brent Crude. A light & sweet crude oil from the North Sea, between the British Isles & mainland northwestern Europe. It’s the most popular benchmark, referenced in ~ two thirds of all oil futures contracts. Easy to transport, & ideal to refine.
🇺🇸🛢️ West Texas Intermediate (WTI). Also a light & sweet oil, from wells in the US. Main problem is that since it’s on land, it’s a bit more expensive to transport to other parts of the world. Used as a domestic benchmark in the US.
🇦🇪🛢️ Dubai Crude. A medium and sour oil from the Middle East, so slightly lower quality than WTI and Brent. Used as a reference point for all oil shipments in the Middle East, usually transported to Asia.
What Can It Do For You
🧺 Portfolio Diversification. Even though oil has high volatility, it’s still a commodity, so adding it to your portfolio can help lower overall risk since it tends to move differently compared to other asset classes like stocks and bonds.
💰 Profit. The oil market is very volatile, as you can see from the price charts above. The sudden drop to negative numbers earlier this year was unprecedented. Risk is very high since unexpected factors (like the pandemic) can wildly swing its price, but with it, comes the opportunity to make lucrative profits, if you know what factors to look out for.
What Affects Oil Prices
Oil prices are highly volatile, sometimes swinging unexpectedly. Knowing what moves the price of oil can help you understand the current situation.
- 🇮🇷🇮🇶🇰🇼🇸🇦🇻🇪 (OPEC/Non-OPEC) Supply. Arguably the most influential player in the oil industry, the Organisation of the Petroleum Exporting Countries (OPEC), as its name suggest, consists of countries that produce a significant amount of the world’s oil supply. Together, they produce ~40% of the world’s oil, and hold ~80% of the world’s oil reserves. As you can see, they control quite a chunk of the oil market, which means any announcements about cuts or increases in production will affect its price.
At the same time, however, non-OPEC members (i.e. everyone else that produces oil) aren’t bound by any agreements made by OPEC members in terms of production cuts/increases, and basically competes with them. As a result, OPEC members have an incentive to not stick to OPEC oil quotas to compete with non-OPEC members (like the US & Russia), in addition to acting out of their own self-interest.
- 🗺️ Global Demand. Demand for crude oil is global. The International Energy Agency (IEA) predicts that global oil demand is currently at 99.9 million barrels a day, with China accounting for more than 80% of oil demand growth last year. They also release a monthly report providing a snapshot of global supply & demand levels.
- ⚡ Disruptive Global Events. Disruptive events like war, conflict, and a pandemic can affect and disrupt global supply & demand dynamics. These events create uncertainty regarding oil production, or drive down global demand.
- 🛢️ Oil Inventory & Reserve Levels. Stored excess supply levels by producers and governments can give a glimpse into supply & demand levels. When inventory/reserve levels fall, it may mean demand is rising, which then signals to traders to buy, increasing its prices. The same is true when inventory/reserve levels fall, which suggests lowered demand/increased supply, signalling to traders to sell, lowering its prices. The US Energy Information Administration (EIA) releases a weekly status on US oil inventories.
- 🌩️ Weather. Weather can definitely impact the price of refined crude prices like gasoline. Adverse weather conditions like hurricanes or rough storms can shut down or damage oil rigs (especially in the sea), as well as potentially delaying delivery to other parts of the world. Rain, heat, snow, etc. can also damage oil pipelines connected to refineries, potentially delaying shipments. Weather can also impact demand. Cold winters will increase demand for electricity & domestic/commercial heating, amongst other things.
- 💵 US Dollar Strength. Like other commodities, the benchmark for the pricing of oil is in US dollars. A weak dollar compared to other currencies (i.e. need more USD to buy other currencies) may incentivise foreign buyers to buy (since their currencies are worth more in dollars & so can buy more copper) & drive up demand, increasing prices, and vice versa.
- 🔋 Advancements In Alternatives. Improvements in alternative sources of energy is slowly but surely competing with oil. Clean energy (wind, solar, etc.) & nuclear sources are on the rise, as well as electric vehicle adoption. Though it’s still currently unclear what the impact that these have on oil, more developments and adoption here will certainly take away from oil in the future.
📉💸 Why Did Oil Futures Prices Go Negative?
Basically, it was a combination of the pandemic hammering demand, oversupply, limited (& costly) storage, and unfortunate timing with near-term futures contracts. Lockdown everywhere meant that no one was driving, so a big chunk of demand disappeared quite literally overnight. While this happened, Saudi Arabia & Russia kept supplying more and more oil in the market because, well they can’t really stop oil gushing out from the ground. We’re not claiming to be well-versed in the finances of running an oil firm, but we imagine that capping a well & stopping production can be more expensive than continuing to pump oil out, which meant more supply is added to the markets. Low oil prices meant everyone wanted to store and wait until prices went back up again. But pretty much almost all of the world’s oil storage capacities were full. Finally, the futures contracts for that month was also coincidentally approaching its expiry, which meant that if traders didn’t sell their contracts, they’d take physical delivery of actual barrels of oil. But since demand was shrinking, nobody wanted to buy it, nowhere to store it (in addition to rising storage costs), traders paid to get rid of their oil, which meant prices went negative.
Where Is Demand Coming From?
Listing over 6,000 products (according to Ranken Energy Corporation) made from crude oil will take too long. The link is here if you want to have a look at some of it. Crude oil is refined into different kinds of liquids, some of which are further refined for use in industries. Here are the major industries that need it:
- 🚗 Transportation. This one’s a big one. Motor vehicles, planes, and ships all require fuel refined from crude oil (diesel fuel, jet fuel, etc.). As we’ve seen in the pandemic, a drop here will affect prices.
- 🏗️ Industrial. Industries also need refined oil for fuel to manufacture, smelt, etc. Lubricants are used to grease up gears to ensure smooth operation. It goes on.
- 🔌 Residential. Electricity generated from crude powers homes. Heating oil refined from crude oil heats homes.
- 💻 Commercial & Public Services. Similar to residential, crude oil provides power and/or heating to commercial & public services. Refined products of crude oil are also further processed to create more products like plastics, cosmetics, medicines, etc.
The Case For Oil
High volatility also means lucrative returns on investment. With its cyclical pattern, there are multiple opportunities to enter & exit with profit. Despite crashing oil prices, crude oil is still the lifeblood of the global economy, with consumption forecasted to go back to near pre-covid levels next year. The lack of demand as well as storage facilities may force producers to cut oil production. Eventually, oil prices will rise, and prices right now may seem like it’s a bargain. Just be wary of further lockdown restrictions that may keep demand low, in addition to any changes in production supply levels from OPEC.
The Case Against Oil
As mentioned above, oil is highly volatile. It can swing unpredictably at times, and unexpected events (like the pandemic) can result in massive price swings. The uncertainty about the status of the pandemic, including further lockdown restrictions, may further dampen crude oil demand in the near future. Furthermore, advancements in alternative sources of energy, as well as further mass adoption of battery electric vehicles, can slowly but surely compete with oil in the long run. With climate change & global warming slowly becoming a main talking point for societies all over the world, institutions and governments may also consider looking to divest away from oil as an energy source and into greener alternatives.
Popular Ways To Invest In Crude Oil — Pros/Cons of Each
If you’re still confused about how any of these work, refer back to our basics newsletter for a refresher.
- Physical Barrels of Oil. Well, it’s technically possible to buy physical barrels of crude oil, but it’s complicated. This comes with a lot of risk in all aspects of the transaction, from purchase, to storage, to eventual sale. First, you’ll need to identify a buyer who’d be willing to sell to you. Then, you’ll need to find suitable storage since crude oil is flammable & hazardous, emitting toxic vapours. Depending on where you live, there will be regulations on this sort of thing. Finally, you’ll need to find a buyer to buy it from you since it’s doubtful that oil refineries will want to buy such small quantities. In short: possible, but with lots of strings attached, and depending on where you’re from, will need to abide by regulations.
- Oil ETFs. Oil Exchange-Traded Funds are traded on stock exchanges, so they’re very easy to buy and sell. There are a number of options here. You can choose ETFs that track the price of oil via rolling oil futures contracts, or ETFs that bundle up oil company stocks. So, depending on what you choose, you may or may not have direct exposure to oil prices. As usual, whichever ETF you choose, be aware of the fine print — the risks and costs.
- Oil Stocks. These are shares of oil-extracting/refining companies. While you will get some exposure to oil prices, there are times when the company’s stock price and oil price diverge, such as events like the BP oil spill. You may want to consider looking at the company’s annual reports (especially operational costs), portfolio of what rigs they have, and potential exploration plans. This option is probably the easiest way to get into oil trading.
- Oil Futures Contracts. A binding agreement traded on futures exchanges between two parties where they agree to buy/sell oil at a specified time in the future with an agreed-upon price. Because you are using a significant amount of borrowed money, even small price changes in oil can either lead to massive profit, or massive losses beyond what you paid for, potentially leaving you in massive debt. They are certainly high-risk and not recommended for beginners. Further, fees associated with futures trading include broker commissions, and exchange/clearing fees.
TL;DR — Is It The Right Investment For You?
As always, it depends on what your aims are. It’s a highly volatile and risky investment that can offer lucrative returns. Even so, it’s still a commodity, so adding it to your portfolio can help you achieve diversification & lower overall portfolio risk. With negative headlines and low oil prices, it may seem like a bargain. Just be wary of future developments that can lower its price even further. Whether you’re looking at oil companies, ETFs or futures, it’s important to know the risks associated with each since the oil industry is very much in uncertain territory right now.
🧺 If you are considering adding oil to your portfolio or bundling it with a number of others, you may want to consider doing dollar-cost averaging (regular investments over time) to build your oil position so you can take advantage of the volatility in the market.
💰 If you are considering trading oil for speculation and profit, you may want to monitor the factors that affect oil prices mentioned above, especially OPEC announcements regarding supply production & news concerning further lockdown restrictions that may further hamper demand. The weekly status updates from EIA & monthly reports from IEA can also give you a snapshot of what’s to come in terms of supply & demand. In addition to monitoring the factors mentioned above, you may also want to consider performing some technical analysis on oil’s price chart to help consolidate trends and patterns to help with your decision.
As always, if you are unsure, check in with a professional financial advisor before making any moves.