🛢️ Your Guide To Investing In Heating Oil, A Natural Gas Alternative Made From Crude Oil
Not to be confused with crude oil, heating oil is made by refining crude oil. As its name suggests, its main use is to heat homes and commercial buildings. You might have a natural gas system or electricity system in your home, but for those who reside in areas that don’t have easy access to main gas lines, heating oil is the ideal choice. It’s generally referred to as a “distillate fuel oil”, categorised alongside other fuel types like diesel, since diesel and heating oil are chemically similar. Since diesel has a higher fuel tax than heating oil, and since they’re both chemically similar, many countries have added coloured dyes to heating oil to catch those evading fuel taxes.
What Can It Do For You
🧺 Portfolio Diversification. As always, adding commodities to your portfolio can help diversify and lower risk. Adding heating oil to your portfolio means owning an asset that tends to act differently to other asset classes, and even to other commodities.
💰 Profit. Like with natural gas, heating oil prices also tend to fluctuate seasonally due to the seasons — typically high demand in the colder winter months, and low demand in the warmer months. This means that this cyclical pattern can provide opportunities for speculative returns. Generally, there is one long-term trend that can act as support for heating oil prices — consistently increasing global consumption. That being said, there are a number of risk factors that can put downward pressure on prices. These include: alternative substitutes, and developments in more energy-efficient materials that is able to retain heat more effectively.
What Affects Heating Oil Prices
Since the heating oil prices fluctuate regionally, we’re going to be focusing on factors that affect the US heating oil market. Furthermore, since heating oil is derived from crude oil, crude oil prices play a major part in heating oil prices. As such, factors that affect crude oil prices can affect heating oil prices too. Have a look back at our crude oil article for a refresher.
- 🌩️ Weather/Seasonality. Weather can definitely impact the price of heating oil. Generally speaking, consumer demand for heating oil increases during the colder winter months, and decreases during warmer months. Occasionally, unexpected cold snaps can lead to a sudden short-term increase in demand, potentially causing a price spike in heating oil.
- 🛢️ Crude Oil Prices. Since heating oil is made by refining crude oil, crude oil prices can definitely affect heating oil prices. As mentioned above, check back to our crude oil article for more info on what drives oil prices.
- 🇺🇸 Regional Logistics & Supply. Generally speaking, transporting heating oil can be an added cost to heating oil prices, especially if the end destination is in a rural area. Though this factor affects prices for consumers more so than for investors, it is still worth noting, since if the US invests in better transportation infrastructure to make transporting heating oil cheaper, this may incentivise consumers to switch to heating oil and increase demand.
- 📦 Stock 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 increase, 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 heating oil. Note that heating oil is also referred to as distillate fuel oil.
- 🔁 Substitution. Heating oil isn’t the only heating fuel that’s available. Other alternatives that consumers can choose from include natural gas and electricity. So, if heating oil prices rise too high, it may incentivise consumers to switch to others, lowering demand, and therefore lowering its price. Similarly, if heating oil prices are low compared to the others, this may incentivise consumers to switch to heating oil, increasing demand, and therefore increasing its price.
- 🌡️ Improvements in Energy Efficiency. Developments in materials that can keep buildings and homes warmer more efficiently can potentially lower demand for heating fuels like heating oil.
Where Is Demand Coming From?
Generally, heating oil is mainly used as a heat source, mostly to warm up homes and commercial spaces, but also water, to an extent. According to the EIA, in the winter of 2019–2020, ~5.5 million households in the US used heating oil as their main heating fuel, with roughly ~81% of this figure based in the Northeast region.
The Case For Heating Oil
Like other commodities, not only can heating oil serve as a portfolio diversification tool & a hedge against inflation, but it can also provide opportunities for speculation and profit, particularly due to the cyclical seasonal price movements in response to fluctuating consumer demand. Overall, according to the EIA, global consumption for distillate fuel oil has been increasing somewhat consistently year-on-year. This can certainly act as support for heating oil prices. Furthermore, since heating oil prices are linked to crude oil prices, market sentiment for crude oil need to also be taken into account. As the world returns to relative normalcy from the pandemic, in the short term, oil prices are likely to recover as demand recovers, which could support heating oil prices as well.
The Case Against Heating Oil
There are a couple of risks involved if you want to get involved with heating oil. Firstly, domestic residential demand for heating oil in the US has been declining year-on-year, and according to the EIA, an increasing number of homes are switching to natural gas & electricity. Reduced domestic demand could certainly put downward pressure on prices. Furthermore, developments in insulation materials that are more efficient in retaining heat can also lower demand for heating oil.
Popular Ways To Invest In Heating 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.
- Heating Oil ETFs. There are a number of ETF options that you can choose from, depending on the your preference on the level of exposure to heating oil, as well as risk levels. There are ETFs that focuses on heating oil, whereas others include it as part of their portfolio. These ETFs are traded on stock exchanges, so they’re very easy to buy and sell. Nevertheless, they’re very easy to buy and sell. However, there are no assurances that you actually own physical heating oil. Depending on which broker you go with, you may be charged with trading commissions. ETFs also charge an expense ratio, or management fee that gets taken out of their total holdings and is then reflected on your account. Whichever ETF you choose, be aware of the fine print — the risks and costs.
- Heating Oil Stocks. These are shares of companies with exposure to heating oil prices. Generally speaking, these companies are involved in crude oil, whether they’re extracting and/or refining it. This means that they also have exposure to crude oil and crude oil products. This means that you aren’t necessarily fully following heating oil prices since there are other factors that come into play. You may want to consider looking at the company’s annual reports (especially operational costs), portfolio of what facilities they have, and potential exploration plans.
- Heating Oil Futures Contracts. A binding agreement traded on futures exchanges between two parties where they agree to buy/sell heating oil at a specified time in the future with an agreed-upon price. The Chicago Mercantile Exchange (CME) offers these contracts through its subsidiary, the New York Mercantile Exchange (NYMEX). contract represents 42,000 gallons of heating oil, and is financially settled after it has expired. Because you are using a significant amount of borrowed money, even small price changes in heating 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. Generally, heating oil prices follows a cyclical seasonal pattern due to fluctuating consumer demand in response to colder and warmer seasons. As such, heating oil can not only be used as a portfolio diversification tool, but it can also provide decent speculative returns.
Overall, global consumption of heating oil has been increasing consistently year-on-year, which presents opportunities for growth in the future. This can certainly act as support for heating oil prices. In the short term, as the world recovers from the pandemic and normalcy returns, oil prices are likely to recover, which could also support heating oil prices. However, domestic demand for heating oil in the US has been declining year-on-year as an increasing number of people switch to natural gas and electricity alternatives, which can put downward pressure on prices. Furthermore, developments in innovative insulation material that is able to retain heat more efficiently can also lower demand for heating oil.
🧺 If you are considering adding heating 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 heating oil position so you can take advantage of the volatility in the market.
💰 If you are considering trading heating oil for speculation and profit, you may want to monitor the factors that affect heating oil prices mentioned above. The EIA provides weekly and monthly updates on production, consumption, stock levels, a short-term outlook, and other bits of information, which can provide a snapshot into the supply and demand dynamics at that point in time. In addition to monitoring the factors mentioned above, you may also want to consider performing some technical analysis on heating 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.