How to invest in oil

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Soaring energy prices have dominated the headlines over the last year. In the oil sector, the wholesale price of Brent crude oil (a key oil industry measure), is almost five times higher now than in April 2022, and motorists have faced record petrol prices at the pumps.

As a result, both oil and gas companies have enjoyed bumper profits, with industry leviathan BP recently announcing a trebling of its quarterly profits.

Shell, another major energy player, and BP are also forecast to pay combined dividends of £9 billion in 2022, according to broker AJ Bell. Dividends are payouts to shareholders met out of companies’ profits.

Despite the impressive figures, Emma Wall, head of investment analysis and research at Hargreaves Lansdown (HL), warns that investors “looking to make money from oil should proceed with caution”. She adds: “as we have seen over the past couple of years, commodities are a volatile asset class”.

With that warning in mind, here’s a closer look at the potential benefits – and downsides – of investing in oil along with the different options of gaining exposure to the market.

Note: market-based investments can go down as well as up, and you may lose some, or all, of your money. You should seek financial advice before deciding whether to invest.

Oil price levels

As with other commodities, the price of oil is a function of global supply and demand.

On the demand side, oil is a critical commodity for the global economy, providing the raw materials for fuel and electricity generation. However, Dan Lane, senior analyst at Freetrade, comments: “We’re quick to assume the whole oil industry exists in lorries and pipelines. It’s less obvious to consider the plastics, tyres and smartphone components it helps create.”

For this reason, economic growth will stimulate demand to meet the energy, transportation and manufacturing needs of industries, while demand will fall during a recession. In contrast, the global transition towards clean energy is likely to reduce future demand for fossil fuels.

On the supply side, one of the main factors is the influence of the Organisation of Petroleum Exporting Countries (OPEC) in setting production levels for its members. Other factors impacting supply include extreme weather events, production issues and geo-political events such as the war in Ukraine.

Cost benchmarks

The oil market is dominated by Brent Crude, which originates from the North Sea, and US-produced West Texas Intermediate. According to the electronic trading platform ICE, the Brent benchmark is used to price 75% of global crude oil traded.

Figure 1 shows how the average Brent Crude oil price has changed over the last 20 years, with the price rising from around $25 (£21) in 2002 to $108 (£94) at the end of July 2022.

The price dropped sharply in 2009 after the global financial crisis, again in 2014 due to excess production and during the pandemic. However, the price has more than doubled since early 2020 as travel and industrial production resumed, while recent sanctions on Russia have constrained supply.

Investing in oil

Chris Beauchamp, chief market analyst at IG, says that “with oil prices so much in the news, it’s natural for investors to look again at investing in oil and oil stocks”.

For retail investors – the likes of you and me – this incorporates two main options.

  1. Investing in oil companies

Freetrade’s Dan Lane says that “this year has shown us how far we are from waving goodbye to oil” with oil being “a huge ecosystem with a lot of angles for investors.”

In addition to the oil giants, he points to the “investable universe encompassing exploration and production among Alternative Investment Market minnows, royalty trusts [special-purpose financing vehicles for oil rights] like BP Prudhoe Bay and commodity traders like Glencore.”

At the same time, HL’s Emma Wall believes that “the most compelling long-term investments in this space are those [companies] that are diversifying their revenue streams and looking to support, and indeed profit, from the carbon transition.”

Historic returns

Outside the Middle East, the largest global oil producers (by market capitalisation) are ExxonMobil and Chevron in the US, while BP and Shell also make the top 10. The table below shows shareholder returns over the last five years:

Company (and ticker)

1-year return

5-year return

Dividend yield (5-year average)

ExxonMobil (XOM)

80%

8%

5.4%

Chevron (CVX)

67%

11%

4.4%

Shell (SHEL)

38%

4%

5.8%

BP (BP)

27%

3%

6.5%

Investors have enjoyed particularly high returns over the last year, with ExxonMobil delivering an 80% return. However, the returns are more modest over a five-year period, with annual returns ranging from 3% for BP to 11% for Chevron.

IG’s Chris Beauchamp comments: “Rising oil prices aren’t a given, of course, and they tend to rise and fall in line with the global economy, but with oil firms there is an objective of smoothing out the peaks and troughs, and the dividend helps to offset the swings in share prices.”

Oil companies may also appeal to income-seekers, with the selected companies above trading on dividend yields (that is, the dividend divided by the current share price) of between 4.4% to 6.5%.

Share ideas

Investing in oil companies is high-risk given the current volatility in oil prices and geo-political uncertainty. However, investors looking for an income-stream with a longer-term investment horizon might like to consider BP as a possible option.

HL’s Emma Wall highlights the appeal of BP’s dividend and buyback policy, alongside its increasing investment in the renewables sector. She comments that “Hydrogen is BP’s focus, which they say has moved forward 15 years in the last two, thanks to increased demand.”

According to Ms Wall, BP’s infrastructure projects in Oman and Australia, together with its disposal of less attractive assets and stake in Russian oil giant Rosneft, are proof that “its stance on renewables is more than just rhetoric”.

2. Investing in oil-based funds

Would-be investors looking to gain indirect exposure to oil via funds have two main options. Both of these involve collective investment products that pool money from investors to be invested in a basket of shares or commodities:

  • Exchange-traded funds (ETFs): ETFs are a simple, low-cost way of investing in oil, either tracking shares in oil companies or, for exchange-traded commodities, the price of oil itself.

  • Actively-managed funds: there are a small number of actively-managed funds that focus on the energy sector.

Historic returns

The table below shows the top two highest-returning funds in each of these categories:

Fund

1-year return

5-year return

iShares Oil & Gas Exploration & Production UCITS ETF

101%

13%

iShares S&P 500 Energy Sector UCITS ETF

106%

12%

BlackRock BGF World Energy

86%

10%

BlackRock Natural Resources Growth & Income

39%

11%

It’s worth noting that three funds comfortably surpassed both the one-year and five-year returns of the four oil companies highlighted earlier. One of the advantages of funds is that their diversified portfolio reduces the risk of one company underperforming, with an average portfolio size of 46 among these four funds.

Broader funds

In addition to specialist energy funds, another option for investors is to consider more broadly invested funds that contain an allocation to the oil sector.

HL’s Emma Wall selects Artemis Income as a possible option for investors looking for oil and gas exposure with “some active management sorting the wheat from the chaff”. She comments that the fund is run “by three experienced managers who look for sustainable dividends from companies with dependable cash streams.”

Ms Wall points to the fund investing in UK dividend stocks, including oil companies, with BP being the second-largest holding in the fund. According to Trustnet, Artemis Income is a top-quartile performer over the last five years with a total return of 19%.

With some of the largest oil companies in the world represented in the UK’s FTSE 100 Index, passive investments such as tracker funds that follow this index are another way of gaining indirect exposure to the sector.

3. Trading in oil derivatives

Another option for making money from the oil sector is to speculate on the commodity’s ‘spot’ and ‘futures’ prices using spread betting companies and sophisticated investments such as contracts for difference. Note that these are extremely high-risk options that are only suitable for professional investors.

Disadvantages of investing in oil

The main disadvantage of investing in the oil sector is its volatility. Freetrade’s Dan Lane comments: “Dividends are high for now but investors need to look for sustainability of revenue streams from the largest cap firms too.”

According to Emma Wall: “Profits are dictated by supply and demand, and while some of this dynamic is easy to model – seasonal fluctuations, new sources and technology – so-called once in a lifetime events, such as a pandemic or war can completely disrupt your calculations.”

Oil is highly dependent on the state of the economy, and is a poor hedge against an economic downturn compared to other commodities such as gold. Investing in fossil fuels, rather than green energy sources, may also pose ethical problems for investors.

In addition, Mr Lane comments that changes in environmental legislation can cause a particular issue for smaller companies. This can also trigger lengthy legal disputes such as drilling firm Rockhopper’s successful lawsuit against the Italian government for banning drilling in an area in which the company had an exploration licence.

With soaring energy prices and oil companies paying significant dividends, investors may be looking to increase their exposure to the oil sector. However, investors should also be comfortable with the high-risk nature of investing in oil, particularly given the current geopolitical uncertainty and the likely price volatility over the next year.

Any investment in oil should therefore form part of a balanced portfolio and commodities should not represent more than, say, 5% of your overall portfolio.

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