A Guide to Investing in Oil Markets

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 explains the forces driving the market and how to have a financial stake in oil-price fluctuations without opening a futures account.

Demand

The Organization of Petroleum Exporting Countries (OPEC) and the International Energy Agency estimate the current world demand for oil at between 97 million to 99 million barrels per day in 2017. When the price of oil rises, this decreases demand in the United States, but demand from growing emerging market economies is expected to increase as these countries industrialize. (For related reading, see What Is an Emerging Market Economy?)

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 products such as diesel and gasoline.

On the supply side, in 2017, approximately 92.6 million barrels of oil were produced each day. The discovery of new reserves in 2017 was the lowest since the 1940s. The amount of reserves found has fallen every year since 2014 as budgets for oil exploration has been cut following the fall of oil prices (For more on oil production shortfalls and their implications, read Peak Oil: What to Do When the Well Runs Dry.)

In OPEC, most countries do not have the ability to pump out much more oil. Saudi Arabia, the one exception, keeps an estimated spare capacity of 1.5 to 2 million barrels of oil per day as of 2018. The United States, Russia and Saudi Arabia are the world's leading producers of oil. (For more on how supply and demand impact the price of oil, read What Determines Oil Prices?)

One of the major problems the oil market faces is the lack of high-quality "sweet" crude, the type of 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 a different refining capacity. Such as the United States, which produces a lot of light crude oil that it can export. Meanwhile, it imports other types of oil to maximize its production based on refining capacity. 

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. (For more on trading oil futures, read Become an Oil and Gas Futures Detective.)

Regardless of the underlying reasons for changes in oil prices, investors who want to invest in oil markets and capitalize on energy price fluctuations have a number of options. One simple way for the average person to invest in oil is through stocks of oil drilling and service companies. (For help in how to choose specific companies in the industry, see Oil And Gas Industry Primer.)

Several sector mutual funds invest mainly in energy-related stocks as well. (For more information on sector mutual funds, see An Introduction to Sector Funds.)

Investors can gain more direct exposure to the price of oil through an exchange-traded fund (ETF) or exchange-traded note (ETN), which typically invest 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. (Learn more about the advantages of ETFs and ETNs in Exchange Traded Notes - An Alternative to ETFs.)

Investors have 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). There are many choices for investors. (For more information on energy investment options, see ETFs Provide Easy Access to Energy Commodities.)

Investing in oil 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. 

For alternative-energy investment options, read The Biofuels Debate Heats Up.