Despite recent pushes to increase the planet’s use of renewable energy, oil still makes the world go round. In 2016, the world used roughly 97 million barrels of crude oil each day. Cars need gasoline to run and power stations need natural gas, oil, and other resources to produce electricity to keep the lights on in our homes.
Because oil is such an essential commodity, many people want to invest in oil and the oil industry. There are many paths you can take to invest in oil, each with pros and cons.
How to Invest in Oil and Natural Gas
There are investment opportunities in the oil and gas industry, as well as to invest in oil and gas directly.
Oil and Natural Gas Futures
Short of buying barrels of oil and storing them in your garage, futures are one of the most direct ways to invest in oil and natural gas (or any commodity). Unfortunately, futures can also be complex and risky.
A futures contract is an agreement between a buyer and a seller to complete a transaction at a set price, at a set date in the future. For example, you could sign a futures contract with an oil seller to buy 1,000 barrels of oil at $50 on June 30, 2021. On that day, you’d pay the seller and they would deliver the barrels to you.
Futures were originally designed for use by large businesses that wanted more certainty in their raw materials costs. If a company relies on a commodity, it can significantly affect its profits if the commodity price changes rapidly. Futures let a buyer secure prices for the raw materials it needs months ahead of the time they actually need to receive the goods, making production costs more predictable.
Investors can now use futures bought and sold through platforms like E*Trade to speculate on changes in commodity prices. If you buy an oil futures contract at $50 and the price per barrel rises to $60, you could sell that contract to another party for a profit. The original seller of the contract must deliver the oil at a price of $50 per barrel, so the holder of the contract gets to buy oil below the market rate.
However, if the price of oil falls to $40, the contract holder won’t be able to sell the contract at a profit. Instead, they will lose money.
Oil futures are popular because they are highly liquid and offer the potential for significant returns. Each futures contract involves 1,000 barrels of oil, so investors can get a large stake in oil at a low cost. However, using leverage also increases risk, so people considering investing in futures should make sure they know what they’re doing and can accept that risk.
Direct Participation in Oil Wells
Another way to get direct exposure to oil is through a direct participation program (DPP). DPPs pool investor money, creating a limited partnership, and use those funds to finance oil-related projects like drilling and extracting oil from a well. In effect, you become a partial owner of an oil company.
DPPs are typically passive investments but have long timelines, often five to 10 years or more. During the DPP’s life, investors receive the partnership’s cash flows. You can also receive tax advantages based on your ownership.
DPPs get involved in oil and gas in many different ways, so it’s important that you understand what your DPP will focus on, such as drilling projects, storing oil, or refining it. Also, make sure to do your due diligence on the partnership’s business plan and management team. If the partnership fails to make a profit, you’ll lose money on your investment.
Buying Mineral Rights
In the United States, mineral rights refer to the ownership of the resources under a piece of land, such as oil, natural gas, and precious metals. Buying mineral rights to land that has these resources under it is another direct method of investing in oil and natural gas.
Although you could, in theory, build your own operation to extract the resources from the land you purchase, this is exceedingly difficult and expensive. Most people who own mineral rights to resource-rich land choose to sell or lease those rights to companies that specialize in extracting those resources.
Leasing the mineral rights of an oilfield to an oil or gas company can be a great way to produce cash flow. A common arrangement is for the landowner to receive royalties based on the amount of oil or gas extracted. If you have resource-rich land, you can earn a significant profit.
Of course, there are risks. One is that mineral rights can be expensive, especially if the land is known to have a lot of valuable resources in it. You may overpay and not receive sufficient returns to cover your costs. You’ll also face risks based on changing commodity prices.
Buying Shares of Oil and Gas Companies
A less direct method of investing in oil and natural gas is to invest in the companies involved in those industries.
This is one of the simplest ways to get exposure to oil and gas in your portfolio. These companies operate in many different sectors of the oil and natural gas industry and you can get started for the cost of a single share, or less if your brokerage lets you buy partial shares.
Stocks are a highly liquid investment and are often less volatile than commodity prices, which can reduce your risk somewhat. Many oil and gas companies also pay dividends, which let you earn a cash flow from your investment.
However, investing in individual stocks can be risky. If the company you choose fares poorly, you could lose money on your investment. You’re also likely to earn lower returns on individual stocks than if you successfully invested more directly in oil and gas.
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Buying Oil and Gas Mutual Funds or ETFs
One of the primary risks of investing in individual stocks is a lack of diversification. If you buy shares in a single company and it loses value, you don’t own other shares that can make up the difference.
Investing in mutual funds or exchange-traded funds (ETFs) is a good way to build a diversified portfolio easily. You can buy shares in a single fund to get exposure to dozens or hundreds of different stocks.
There are many funds and ETFs that focus on specific industries, like oil and natural gas, so you can find one that you like and start buying shares.
While the diversification offered by mutual funds reduces your risk, it also reduces your potential profits. If one of the stocks in the fund gains a lot of value, losses in other shares may reduce your returns. You also have to pay a fee — called an expense ratio — to invest in mutual funds and ETFs, which will reduce your returns.
Types of Oil and Gas Companies
If you want to invest by buying shares in oil companies or buying shares in funds that own oil and gas companies, it’s important to understand the different types of oil and gas businesses, their benefits, and their risks.
Upstream: Exploration and Production
Upstream companies focus on the first steps in the oil and natural gas supply chain.
Exploration includes buying land and mineral rights and trying to find locations that have oil, natural gas, and other resources. These companies can buy land known to have these resources or make educated guesses when purchasing land in hopes of finding large caches that previous owners didn’t identify.
If an exploration company buys land that is rich with natural resources, they can earn massive profits. However, they could also lose huge sums by overpaying for land with little or no oil or gas in it, leaving them with worthless real estate.
Production companies focus on developing land that contains oil and natural gas, and extracting it from the ground. Some companies do both exploration and production while others focus solely on production.
Midstream: Transportation and Storage
Midstream oil and gas companies focus on the middle part of the supply chain.
Once oil and gas are out of the ground, they need to be transported to refineries where they become more useful products. Midstream companies handle transportation and storage. They may use pipelines, large oil tankers, trucks, or simple warehouses that can store barrels of oil.
Downstream: Refining and Sales
Downstream oil and natural gas companies take the raw materials and turn them into more useful products, such as gasoline or heating oil.
These companies also sell the finished goods to consumers or to other companies that will further refine them before selling to consumers.
Although some companies specialize in one aspect of the oil and gas industry, integrated companies are involved in multiple steps. An integrated oil company, for example, might operate its own wells, have a fleet of tankers that can move the oil from wells to a refinery, and own a refinery that turns oil into gasoline.
Integrated companies have the potential for higher profits because they control every aspect of the supply chain. That lets them keep raw material costs lower because they don’t have to earn a profit at each step of the process.
However, integrated companies are more complex to run. Businesses that focus on a single aspect of the oil and gas industry have fewer moving parts and can focus on making their operations as streamlined and efficient as possible.
Oil service companies don’t have direct involvement in the oil supply chain. Instead, they supply the companies that are involved in oil production and refinement.
For example, an oil service company may make the parts that go into building oil wells or produce the tankers that midstream companies use to transport oil from one location to another.
These companies give investors some amount of exposure to the oil industry, but they often produce products for many types of businesses, which means they have other, unrelated benefits and risks.
Advantages and Disadvantages of Oil and Gas Investments
Investing in oil and gas can be exciting, but there are a few pros and cons to consider before you get started.
Here are the main advantages to investing in the oil and gas industry:
- Diversification. Historically, oil and gas companies have provided useful diversification in an investor’s portfolio. Because oil and gas are essential parts of the economy and especially transportation, rising gas prices often weaken other sectors of the economy. Exposure to oil can provide a hedge against falling prices in other companies’ shares.
- High Profit Potential. People who invest in oil and gas have the potential to make a lot of money, especially if they get more directly involved through a DPP or investing in futures. A single oil well can produce multiple times its cost in revenues if an oil producer gets lucky.
- Income. Many oil companies are blue-chip companies that have been around for a long time. Blue-chips like Exxon Mobil, Chevron, or BP offer high dividend yields. That means investors can use their investment portfolio to produce passive income.
- Tax Benefits. Oil and gas companies get some tax benefits from the government that aren’t available in other industries. For example, gas and oil drillers can deduct land depreciation as they deplete natural resources from the land they own. If you own shares in large companies, you may not see these benefits directly, but those with direct investments in oil and gas, such as through a DPP, may see significant tax savings.
Oil and gas investments are not without risks. Here are the most notable downsides:
- Volatility. Commodities in general, and oil and gas in particular, can be highly volatile. When you’re investing in an industry based on a volatile commodity, you can expect volatility regardless of how you invest. Some investments, such as in exploration companies, will be more volatile than others but you still need to accept that your portfolio can gain and lose value quickly.
- Liquidity. Some types of oil investments can be hard to buy and sell quickly, so your investment will be tied up for a long time. Investments in shares, mutual funds, and ETFs are easy to liquidate but if you buy mineral rights or get involved in a DPP, you’ll have to plan on the investment being long-term.
- Renewable Energy. Burning oil and natural gas produces carbon emissions, which have become more and more of an issue in recent years. Although many of the companies in the oil and gas industry have taken steps to reduce their environmental impact or begin working in the renewable field, as renewables become more popular, oil and gas businesses may lose value.
- Costs. No matter how you invest, you’ll probably have to pay some kind of fee. Mutual funds and ETFs charge management fees and some brokerages charge commissions on stock trades. However, more direct investments in oil and gas, like DPPs, can involve high fees or commissions, which can impact your bottom line.
- Complexity. The greatest potential rewards in oil and gas investments come from more direct investments such as buying mineral rights or getting involved in partnerships. However, these investments are also the most complex, so you need to have a strong understanding of the industry and these investments before you can get started.
Oil and gas are two of the most important commodities in the modern world. Investing in them has the potential to generate significant profits for you, but commodities can also be volatile and risky.
If you want to invest in oil and gas, do so with a portion of your portfolio that you’re willing to risk and can afford to lose. Use the rest of your savings to construct a safer, diversified portfolio that you can rely on to gain value over the long term.