The oil market can be very confusing to both the professional and individual investor, with large price fluctuations sometimes occurring on a daily basis.
This article gives a broad overview of the forces driving the oil market and how to have a financial stake in oil in your investment portfolio.
Key Takeaways
- As a commodity, the price of oil in the market depends on supply and demand, but its supply is somewhat controlled by the OPEC cartel.
- Different grades of oil trade under different markets such as West Texas Intermediate (WTI) or Brent. It may also be "light" or "sweet" in nature.
- Oil is sometimes seen as a portfolio diversifier and a hedge against inflation.
- Buying and selling physical oil is not an option for most investors, but liquid markets that track oil prices can be found via futures, options, ETFs, or oil company stocks.
Demand
Oil is a global commodity. The U.S. Energy Information Administration (EIA) estimates the world's demand for oil at more than 98 million barrels per day in 2023, an all-time high. When the price of oil rises, it tends to lower the demand in developed, but demand from growing emerging market economies is expected to increase as these countries industrialize regardless of the price of oil.
Some emerging market economies have fuel subsidies for consumers. However, subsidies are not always beneficial to a country's economy, because although they tend to spur demand in the country, they may also cause the country's oil producers to sell at a loss. As such, removing subsidies can allow a country to increase oil production, thus increasing supply and lowering prices. In addition, cutting subsidies can decrease any shortage of refined products, since higher oil prices give refineries an incentive to produce productssuch as diesel and gasoline.
Supply
On the supply side, in 2023, approximately 101 million barrels of oil will be produced each day, another new record, but oil exploration in general has seen a slowing trend. The discovery of new reserves in 2017, for example, was the lowest since the 1940s, and the amount of reserves found has fallen every year since 2014 as budgets for oil exploration have been cut following the fall of oil prices through the 2010s.
In OPEC, most countries do not have the ability to pump out much more oil. Saudi Arabia, the one exception, keeps anestimated spare capacity of 1.5 to 2 million barrels of oil per day.
Oil companies report their oil reserves in their financial statements using one of two available methods. They can use the full cost or the successful efforts method in their accounting.
In the spring of 2020, oil prices collapsed amid the economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows. Markets, however, quickly recovered and the price of oil rose. In 2022, when Russia invaded Ukraine, the disruption to oil markets, economic sanctions, and rising inflation led to oil trading above $125 per barrel.
Quality and Location
One of the major problems the oil market faces is the lack of high-quality sweet crude, the type of low-sulfur oil that many refineries need to meet stringent environmental requirements, particularly in the United States. This is why, despite the rising production of oil in the United States, it must still import oil.
Each country has adifferent refining capacity. For instance, the United States produces a sizeable amount of light crude oil that it can export. Meanwhile, it imports other types of oil to maximize its production based on refining capacity.
There are also differences in terms of where oil is produced for sale. For example, the major difference between the crude oils Brent Crude and West Texas Intermediate is that Brent Crude originates from oil fields in the North Sea between the Shetland Islands and Norway, while West Texas Intermediate is sourced from U.S. oil fields, primarily in Texas, Louisiana, and North Dakota. Both Brent Crude and West Texas Intermediate are light and sweet, making them ideal forrefininginto gasoline.
Speculation
Aside from supply and demand factors, another force driving oil prices has been investors and speculators bidding on oil futures contracts. Many major institutional investors now involved in the oil markets, such as pension and endowment funds, hold commodity-linked investments as part of a long-term asset-allocation strategy.
Others, including Wall Street speculators, trade oil futures for very short periods of time to reap quick profits. Some observers attribute wide short-term swings in oil prices to these speculators, while others believe their influence is minimal.
Oil Market Investment Options
Regardless of the underlying reasons for changes in oil prices, investors who want to invest in oil markets andcapitalize on energy price fluctuations have a number of options. The bulk of oil trading takes place in derivatives markets, utilizing futures and options contracts. These may be out of reach for many individual investors, but there are several other routes to add oil to your portfolio.
One simple way for the average person to invest in oil is through stocks of oil drilling and service companies. In addition, investors can gain indirect exposure to oil through the purchase of energy-sector ETFs. Several sector mutual funds that invest mainly in energy-related stocks are available like the iShares Global Energy Sector Index Fund (IXC), and energy-sectormutual funds, like the T. Rowe Price New Era Fund (PRNEX). These energy-specific ETFs and mutual funds invest solely in the stocks of oil and oil services companies and come with lower risk.
Investors can gain more direct exposure to the price of oil through an exchange-traded fund (ETF) or exchange-traded note (ETN), which typically invests in oil futures contracts rather than energy stocks. Because oil prices are largely uncorrelated to stock market returns or the direction of the U.S. dollar, these products follow the price of oil more closely than energy stocks and can serve as a hedge and a portfolio diversifier.
How Can Ordinary Investors Start Trading Oil?
There are many choices for investors, including a number of ETF and ETN options to choose from, such as a single-commodity ETF (e.g., oil only) or a multi-commodity ETF that will cover a variety of energy commodities (oil, natural gas, gasoline, and heating oil). Investors can also look to oil company stocks or ETFs that track companies in the oil sector.
How Much Crude Oil Is There Left in the Ground?
As of mid-2022, there are estimated to be around 1.43 trillion barrels of oil left to be drilled. At current rates of consumption, that is estimated to last just 45 more years.
Which Country Produces the Most Oil?
As of 2022, the United States has become the world's largest producer of oil, in part due to extraction from shale oil deposits. The U.S. is followed by Saudi Arabia, Russia, Canada, and China.
The Bottom Line
Investing inoil markets means investors have a diverse array of options. From indirect exposure via an energy-related stock to more direct investment in a commodity-linked ETF, the energy sector has something for almost everyone. As with all investments, investors should do their own research or consult an investment professional.
