What Is an Oil ETF?

Oil ETFs Explained

Two workers an oil drill
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Call it black gold or Texas tea. Oil can translate into big money by any name, and maybe you'd like to be an oil tycoon or at least have oil investments as part of your trading strategy. But stocking up on barrels of oil in your garage makes for an inefficient method of portfolio diversification, not to mention that it's a fire hazard.

You can begin safely investing in crude oil by learning some background and then investing in crude oil exchange-traded funds (ETFs).​

Key Takeaways

  • ETFs allow you to include oil investments in your strategy without directly investing in the company stocks of an oil producer.
  • You can make one purchase at one price and save on commissions.
  • Inverse oil ETFs track the price of oil or an oil index in the opposite direction. This can make sense if you want to short oil, but you can't sell your ETFs due to margin or account restrictions.
  • You can usually short ETFs, use limit and stop-loss orders, and apply trading strategies as you add them to your portfolio.

Definition and Example of Oil ETFs

Oil commodity ETFs provide a simple way to expose your investment strategy to the price and performance of oil without actually owning any oil itself. Oil ETFs consist of either oil company stocks or futures and derivative contracts that track the price of oil, or oil-related indexes in some cases.

One of the most popular oil ETFs is USO, the United States Oil Fund. You don't actually own the oil in this particular ETF. The fund consists of futures, options, and forward contracts for different oils, gasses, and petroleum-based fuels. This gives you exposure to the price of oil without having to buy barrels of the actual stuff. But that's not necessarily to say that the investment will be any safer or less volatile than investing directly.

USO closed at $22.48 per share at the end of trading on Tuesday, April 21, 2020, down over 90% since its inception in April 2006. It announced that same day that it would invest approximately 40% of its portfolio in crude oil futures contracts for June, about 55% of its portfolio in crude oil futures contracts for July, and about 5% of its portfolio in crude oil futures contracts for August.

This change made by USO came on the heels of volatile market conditions in the crude oil markets.

How Do ETFs Work?

Oil ETFs take all the extra work out of investing in oil. You would typically have to make individual purchases of oil company stocks if you wanted to invest in the oil industry. You would also be burdened with the decision about which companies to choose.

You would have the challenge of purchasing all the equities in the index basket to target a certain price, even if you decided to invest in an oil index such as the OSX, PHLX Oil Service Sector. Complications and commissions would make it quite difficult to achieve your investing goal.

But you would make one purchase at one price and save on commissions in the case of an oil ETF such as OIH, the VanEck Oil Services ETF that tracks the MVIS U.S. Listed Oil Services 25 Index. The oil ETF is already bundled ahead of time. You have instant exposure to the price of oil from a variety of securities with one trade.

Are Oil ETFs Worth It?

You'll also enjoy advantages from a tax perspective when you consider an oil ETF for your portfolio. Capital gains taxes aren't incurred until the sale of the fund. This gives ETFs some huge tax advantages over other investments such as mutual funds.

You'll have the added benefit of easier trading as well because you can get in and out of ETFs at any time. You can trade them directly as you would the stocks in your portfolio instead of having to go through a broker-dealer or mutual fund company.

You'll pay lower fees as compared to a mutual fund, and you can short ETFs, use limit and stop-loss orders, and apply any trading strategies you'd like as you add ETFs to your portfolio.

This isn't to say that there aren't limitations when trading ETFs. But ETFs could be a great addition to your portfolio if you understand how they work.

How To Diversify Oil ETFs

You have all sorts of strategic trading options with oil ETFs because you can trade them like you would individual stocks. You can sell an oil ETF with one trade and help reduce your downside oil risk if you want to stabilize some oil investments in your portfolio.

You can also use oil ETFs to hedge the downside risk for both industry and foreign investments. You can sell an oil ETF to hedge your downside risk if you hold long positions in several oil stocks.

Do you have foreign investments in a country that has oil as a major source of income? This would be another opportunity to sell an oil ETF to protect you from downside risk.

You also have the option of purchasing an inverse oil ETF which tracks the price of oil or an oil index in the opposite direction. Inverse ETFs can make sense for investors who want to short oil, but they can't sell ETFs due to margin or account restrictions.

Inverse ETFs come with very high risk. They can help hedge against a down market, such as allowing you to profit off a steep drop in oil price, but they can also lose you money if the price goes back up. Keep your risk tolerance in mind before investing.

Alternatives to Oil ETFs

You might consider investing directly in oil companies, but make sure you have expert advice. The firm or individual who's arranging your investment should be registered with the Securities and Exchange Commission and be a Financial Industry Regulatory Authority (FINRA) member. Both offer online tools that will let you look into anyone you're considering.

Another strategy that may help protect your oil ETF investments is trading oil ETF options. This could work in your favor if you don't want to close your ETF positions but want some short-term exposure or protection.

Otherwise, the Federal Reserve Bank of St. Louis regularly updates crude oil prices on its website to help you track them if you determine that staying in ETFs is your best option.

Frequently Asked Questions (FAQs)

What are the first steps I should take if I want to trade in oil ETFs?

Conduct thorough research first if you're ready to include oil ETFs as part of your investment strategy. Track oil prices and pay attention to how some of the major oil ETFs react to different market conditions. You can get started by including oil ETFs and ETNs in your investing arsenal when you have a good feel for the commodity.

What are some of the best oil ETFs to invest in?

As of early 2022, some of the best oil ETFs include the United States Oil Fund, Vanguard Energy ETF, and the iShares U.S. Oil Equipment and Services ETF. But check with an investment advisor to make sure these meet your needs.

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