How to Invest in Crude Oil the Right Way – Motley Fool

Investing in crude oil requires careful consideration, because you have many different choices. Because crude oil is a physical commodity, directly investing in oil requires proper handling and management of the physical good, and that involves logistics that many traditional investors in the stock market aren’t comfortable taking on in their portfolios. There are other ways to invest in crude oil that offer simpler handling, and they have advantages and disadvantages as well. Among the ways to invest in crude oil are:

  • Owning physical crude oil itself.
  • Investing in crude oil futures contracts that give you the right to take future possession of the physical commodity.
  • Investing in exchange-traded funds that seek to track the price of crude oil.
  • Investing in energy companies that explore for, produce, transport, refine, or sell crude oil.

We’ll look at each of these investments.

Owning physical crude

Owning actual crude oil ensures that the value of your investment will rise or fall with the market price of crude, but it’s very difficult for the ordinary investor to do. Storing crude oil requires special handling because crude oil is toxic and volatile. Typical storage facilities include rail tankcars and the huge oil storage tanks that you see near refineries and pipelines, and the sheer volume of crude is more expensive than most ordinary investors want to invest. Add in storage fees, and the shortcomings of directly owning crude outweigh the advantages for most investors.

Crude oil barrels.

Image source: Getty Images.

Investing in crude oil futures contracts

Crude oil futures contracts offer a method for investors to get exposure to price of crude without having to deal with the storage and other issues involved in owning the physical commodity. Futures contracts let you arrange to buy or sell a certain amount of oil in the future, with the price fluctuating with the market. If you buy a futures contract and the price of crude goes up, then you profit. If it falls, then you’ll lose money, and the contract seller will end up being the one to make money on the contract.

Crude oil futures contracts give investors the chance to have a highly leveraged investment. For instance, the contract unit for CME Group crude oil futures is 1,000 barrels, currently worth around $50,000. However, the current maintenance margin required is just $2,500, meaning that you only need about 5% of the total contract value in your futures brokerage account. That doesn’t prevent you from suffering losses above that amount, however, so it’s important to understand that this leverage is a tool that can work for or against you.

Investing in crude oil ETFs

Exchange-traded funds make it easier for investors to invest in certain areas, and there are crude oil ETFs that offer exposure to the price of the commodity. However, it’s important to understand how such ETFs work, because in some cases, they won’t perform the way you might expect and can therefore be disappointing over the long run.

The United States Oil Fund (NYSEMKT:USO) is the best-known oil-tracking ETF, with the goal of moving up or down in line with the price of West Texas Intermediate crude oil futures on a daily basis. The fund does a good job of accomplishing that goal, but what it doesn’t do is track longer-term changes in crude. Because the ETF doesn’t want to take physical possession of crude oil, it simply rolls futures contracts forward when one expires. The main problem with that strategy is that futures contracts for the current month tend to be less expensive than contracts for future months. The result is that the fund usually takes small losses every month because of the rollover process, and over time, those losses add up to become very large declines — even when oil prices are flat or trending higher.

Owning stocks of companies in the crude oil business

The best way for most investors to invest in crude oil is through the companies that explore for, produce, transport, refine, and sell crude. Some of these companies, such as exploration and production companies, tend to rise in value when crude climbs and fall in value when crude drops. Other parts of the industry have more complex correlations with crude prices. For instance, the refinery industry relies on crude oil as an input for producing gasoline, diesel fuel, and other refined products. If crude oil prices rise without a corresponding increase in the price of refined energy products, then investors can expect refinery stocks to fall, because their profits go down.

Individual stocks are available for investors, but you can also buy energy ETFs that own a wider variety of stocks in the industry. By choosing companies that can profit both from rising oil prices and through smart operational decisions, you can increase your chances of investing successfully.

Investing in crude oil has plenty of profit potential, but you should focus on the methods of investing that work best. Most investors are most comfortable finding stocks that will benefit from crude oil movements rather than buying crude directly on their own.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.