Four ways to invest in oil

People are again looking for the best way to invest in oil, as the price has bounced back from its lows.

Oil certainly tends to be one of those investments that goes in and out of fashion.

However there are legitimate reasons why you might want to invest in oil:

• To hedge the cost of petrol
• Because you think the rising price could hurt stocks
• You think supplies are running out and so it will get more valuable
• You believe inflation is a threat, so want to buy real assets
• When you were little, J. R. Ewing was your idol

To invest in oil, you don’t need to buy barrels of the stuff, though in the last bull market there was talk of hedge funds being forced to take delivery of tankers. (I’d love to see them rolling barrels down the streets of Mayfair!)

Here are four ways to invest in oil without dirtying your hands.

1. Invest in oil with an ETF

I’ve written before about using these collective vehicles to diversify your portfolio with commodities.

In short, ETFs provide an easy way to get exposure to a wide range of commodities.

The price of an oil ETF reflects the spot price of oil.

You buy the ETF just like any other share in your normal share dealing account.

• If the oil price goes up your investment rises by very close to the same amount.
• If the price falls, so does the value of your investment.

You can get exposure to the price in dollar or sterling terms, depending on which ETF you choose.

You can also bet on the price falling by shorting the ETF. I’ve known investors in oil companies attempt to hedge away their exposure to a falling price like this, although it’s an inexact science.

There some slight complications to be aware of:

• Firstly, ETFs are only as secure as the company that backs them. (This was a worry with the threat to AIG and the collapse of Lehman Brothers in 2008).

• Certain commodity ETFs buy the physical goods (at least in theory) but most use only financial instruments to get exposure.

• Finally, there is a fiddly argument about how a commodity ETF does not perfectly track the price, but rather is affect by something called cotango, which is to do with how the market sees the price changing (I’m deliberately over-simplifying). I’m not convinced this will really make a big difference to how your investment performs, although I’ve no trouble believing it adds some ‘frictional’ losses.

Steer clear of any ETF that uses leverage to double or triple the rise or fall of the price. It won’t double (or halve) your investment.

Leveraged ETFs are really bad news unless you’re a day-trader – they are settled daily, are costly, and they don’t do what most investors think they do.

2. Invest in oil via explorers or producers

Buying shares in oil companies is a time-honored method of getting exposure to the oil price. And for once, UK investors have it good, with a range of large, medium-sized and small cap companies.

It’s pretty clear how a rising price benefits these companies.

Oil explorers make more money when the price rises because the reserves they discover and map out are worth more money. And producers make more money by charging more for their barrels.

However it’s not a perfect correlation. Companies will also be affected by general stock market sentiment, for instance, or by the availability of finance (a particular issue for explorers, who are forever looking for cash).

If you want to purely track the price, use either ETFs or a spreadbetting account.

If you’d rather buy companies, in the UK you could look into BP and Shell at the multinational level, Cairn Energy, Dana Petroleum and Soco International at the mid cap point, or the likes of Tullow or Falkland Oil and Gas at the smaller end.

Investing in oil companies is risky, and requires different skills (or luck, tracker fans!) to investing in most other companies.

For explorers, for instance, instead of P/E ratios and growth rates, you have to evaluate possible versus probable versus proven reserves, and estimate the cost of extraction. True ‘oilies’ pour over seismic data and drilling reports to try to spot something even the analysts have missed.

Producers are a little more conventional, but most are on some level explorers or at least acquirers (because their store in the ground eventually runs out!), which takes you back to the reserves question.

It’s specialist stuff really, so I’d suggest most people who want to invest in oil companies are best using a collective fund like the Junior Oils Trust. That manager favours small-to-medium sized explorers, and there’s no danger of your single company investment hitting successive ‘dusters’ on ‘spudding’ since your money is spread between many outfits.

What about simply buying BP or Shell to invest in oil? They have billions of barrels in reserves, and would seem to be major beneficiaries of any rise in the spot price. They are huge companies and pay a great dividend, too.

Unfortunately, the consensus is that these so-called integrated majors are NOT a good play on the spot price.

As best I understand it (and I must admit I don’t entirely), the issue is that the processing and distribution end of the operation effectively has to buy oil from the exploration and production side of the business.

This means if the spot price rises, one side of the business wins and the other loses, canceling out the gains. And vice versa.

To me it still seems like a doubling of the oil price would double the value of its reserves (surely the consumer will be paying the extra ‘downstream’ costs in the end?) but smart oilies tell me it ain’t so.

If you’d like to have a crack at explaining, please do comment below! 🙂

3. Invest in oil by tracking the Russian market

The benchmark Russian RTS stock index is stuffed full of energy giants, and the country is often seen as a play on the energy sector.

More specifically, as John Authers reports in the Financial Times, the performance of the Russian economy is closely correlated to the oil price:

A presentation by Marshall Goldman, professor of Russian economics at Harvard university, shows that every year since the fall of the Soviet Union until [2008], Russian oil production and Russian gross domestic product moved in the same direction: the severe recession of the Yeltsin years correlated with declining oil production, while the Putin years saw booming economic growth on the back of rising production. Last year growth remained healthy, while production declined slightly.

So Russia’s stocks appear to offer a perfect geared play on oil, and economic fundamentals confirm that it makes sense to treat them that way. If you think oil is going down, short Russian stocks; if you are confident about oil, buy them.

I’ve got a small investment in Russia via the JPMorgan Russian Securities Investment Trust, which seems a decent proxy for the market. I’m not aware of a Russian ETF for UK investors, but there may be one.

Alternatively you may be able to spreadbet the Russian index if you’re adventurous.

Russian securities are not for the faint-hearted; Russia is run according to the Don Corleone school of economics.

You’re definitely taking on extra political risk if you invest in oil via Russia (one risk being that you wake up to find the entire market has been nationalised!)

On the other hand, by investing in the index you might get a little more bang from your buck, if the country matures and its market broadens. (Remember though that this would weaken the correlation with the oil price).

4. Spreadbetting the spot price

Spreadbetting provides the very simplest way to get exposure to the oil price – even more so than using an ETF.

To get exposure you simply take out a bet that the price will rise beyond a certain level.

• If the price rises above a small percentage (the spread) you’re in profit.
• If it falls, you lose money.

Make sure you’re very familiar with the many risks and pitfalls of spreadbetting, which are mainly to do with leverage. Spreadbetting accounts are not for everyone.

You don’t have to use leverage when you spreadbet. Or, even when you do, you can be disciplined and put aside the equivalent amount of money into an instant access cash savings account, so that you can answer any margin calls should your spreadbet company ring you up for more cash.

Most people don’t do that though. Instead, they get excited by the spreadbetting software, take out-sized bets, and lose their money.

If you decide to invest in oil, you’re already taking a very specific risk. Don’t turn investing into gambling!