If you are paying more for gas for your car, it may be a good time to invest in oil. When inflation is rising, investing in the oil sector can provide a hedge. Oil is considered a good hedge against inflation because oil companies can pass on higher costs by charging you more at the pump.
Central banks will then increase interest rates to lower inflation. As it becomes more expensive to do business, stocks and bond prices will decline, and oil prices will rise. As you can see, oil is involved in a square dance with the economy that can lead to price volatility.
Volatile Oil Prices
Oil prices move in relation to many other factors that influence supply and demand. When oversupply or a shortage of oil happens, oil prices become volatile. Oil production by OPEC member countries has a strong influence on oil prices. They produce about 40% of the world’s oil.
Until 2005, oil prices traded under price controls for under $30 a barrel. In 2008, oil prices jumped to a record high of $145 a barrel but ended the year at $30. Oil prices jumped back over $100 in 2011 and have been falling since the summer of 2014. Are you getting dizzy yet?
A Staple of the Economy
Despite these heady price moves, because oil runs our economy it is considered less sensitive to the economic cycle. Crude oil, sometimes called black gold, is pumped from the ground and refined into many products used in our daily lives. Once shipped to a refinery, oil is converted into fuel oils, diesel fuel, gasoline, liquid petroleum gas, jet fuel, and many other by-products. They fuel our homes, factories, commercial buildings and transportation. Crude oil is also refined into hydrocarbons, which are used in many products including paints, medicines, and detergents.
There are many ways to invest in crude oil. You can invest directly in the commodity or companies that explore, produce, transport and refine crude oil. Integrated oil companies perform all or many of these tasks, and thus provide diversification. Many oil stocks pay high dividends.
How you do in oil investments, though, will also depend on what part of the oil cycle you invest in and when. When oil prices are low, it is a good time to look for undervalued stocks. The stock price of the big majors such as Chevron, Exxon, and Royal Dutch Shell is trading below the energy and minerals sector. These majors typically trade in line with the energy sector. So it is a good time to ask, should I be picking up these stocks while they are cheap?
Total SA (TOT) is a major trading above the energy sector, a trend it has maintained since 2013. The French oil major is involved in upstream and downstream oil operations, renewable energy and liquefied natural gas. The diversified energy company gets a boost from its refining and chemicals business when the exploration and production sectors are slow.
Exchange-traded funds (ETFs) trade like stocks on exchanges. The major sectors of the oil business trade as ETFs. This allows you to take advantage of the troughs in the cyclical oil sector. Shares of E&Ps and refiners rise at different points in the oil cycle. When oil prices are low, some oil drillers will decide it is not cost efficient to continue drilling and will idle their equipment. The economy still consumes lots of energy. Oil supplies are at all-time highs, so refiners can keep producing oil products even if E&P activity drops off. When oil prices are low, a refining ETF such as Market Vectors Oil Refiners ETF (CRAK) is a good investment.
The S&P Global Energy Index Fund (IXC) is a good diversification play on oil stocks. It tracks the large diversified oil companies such as Total SA and Royal Dutch Shell. The Energy Select Sector SPDR provides exposure to US oil majors such as Exxon and Chevron.
ETFs investing directly in oil can be more volatile. The United States Brent Oil Fund (BNO) and United States Oil Fund (USO) provide exposure to the Brent Oil and West Texas Intermediate crude oil contracts, respectively.
Whether prices are moving up or down, crude oil futures provide the opportunity to bet on the direction you think oil prices are going to move in. Rather than buy oil outright, oil futures let you buy an option on a right but not an obligation to buy or sell oil at a predetermined price at a future date (typically, in 3 months). If you buy an option to sell oil in three months – betting that oil will decline – and oil prices rise, you can choose not to exercise the option. You will only be out the cost of the option. Crude oil is the most heavily traded futures product.
If the Saudis uphold their pledge to ensure stable oil prices, the volatility in oil prices in recent years may stabilize. Oil prices may refind their footing and be less likely to engage in another dance, contango – when the futures price of oil is less than the price in the market today.
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