Black gold, Texas tea—oil can translate into big money, and maybe you’d like to be an oil tycoon yourself or at least have oil investments as part of your trading strategy. Stocking up on barrels of oil in your garage, though, makes for an inefficient method of portfolio diversification, not to mention a fire hazard as well.
You can begin safely investing in crude oil without becoming the neighborhood gas station by learning some background and then investing in crude oil exchange-traded funds (ETFs).
The Basics 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, in some cases, oil-related indexes.
For example, one of the most popular oil ETFs is USO, the United States Oil Fund. In the case of this particular oil ETF, you do not actually own the oil. Instead, the fund consists of futures, options, and forward contracts for different oils, gases, and petroleum-based fuels. So you have exposure to the price of oil without buying up any barrels of the actual stuff—but that's not to say the investment will be any safer or less volatile than investing directly.
For example, USO closed at $2.81 per share at the end of trading on Tuesday, April 21, 2020, down over 90% since its inception in April 2006. It also announced that same day that it would now 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. The change came on the heels of volatile market conditions in the crude oil markets.
Why Buy an Oil ETF?
Oil ETFs take all the extra work out of investing in oil. Typically, if you wanted to invest in the oil industry, you would have to make individual purchases of oil company stocks. You would also be burdened with the decision about which companies to choose.
Even if you decided to invest in an oil index such as the OSX, PHLX Oil Service Sector, you would have the challenge of purchasing all the equities in the index basket in order to target a certain price. Complications and commissions would make it quite difficult to achieve your investing goal.
However, in the case of an oil ETF, like OIH, the VanEck Vectors Oil Services ETF (which tracks the MVIS U.S. Listed Oil Services 25 Index), you make one purchase at one price and save on commissions. The oil ETF is already bundled ahead of time, and with one trade, you have instant exposure to the price of oil from a variety of securities.
Benefits of Investing in Oil ETFs
When you consider an oil ETF for your portfolio, you'll enjoy advantages from a tax perspective. Capital gains taxes aren’t incurred until the sale of the fund, giving ETFs huge tax advantages over other investments such as mutual funds.
You'll also have the added benefit of easier trading, because you can get in and out of ETFs at any point since you 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, among the many other advantages of ETFs.
None of that is to say that there aren't limitations when trading ETFs. But if you understand how they work, ETFs could be a great addition to your portfolio.
Strategies for Trading or Diversifying Oil ETFs
Since you can trade oil ETFs like you would individual stocks, this opens them up to all sorts of strategic trading options. For example, if you want to stabilize some oil investments in your portfolio, with one trade you can sell an oil ETF and help reduce your downside oil risk.
You can also use oil ETFs to hedge the downside risk for both industry and foreign investments. If you hold long positions in several oil stocks, you can sell an oil ETF to hedge your downside risk.
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 make sense for investors who want to short oil, but can't sell ETFs due to margin or account restrictions.
Inverse ETFs can also come with very high risk. While they can help hedge against a down market—such as allowing you to profit off a steep drop in oil price—they can also lose you money if the price goes back up. Keep your risk tolerance in mind before investing.
One more strategy that may help protect your oil ETF investments is trading oil ETF options. If you don’t want to close your ETF positions, but want some short-term exposure or protection, trading oil ETF options could work in your favor.
Investing in Oil ETFs
If you’re ready to include oil ETFs as part of your investment strategy, conduct thorough research first by tracking oil prices and paying attention to how some of the major oil ETFs react to different market conditions. Once you have a good feel for the commodity, you can get started by including oil ETFs and ETNs in your investing arsenal.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.