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How to invest in oil – and how not to

Written by: Adam Laird
After years of falling prices, there has naturally been a lot of interest in oil as an investment. Adam Laird of Hargreaves Lansdown says there are some good ways to invest in oil, but there are some real pitfalls too.

What has happened to oil?

Much of the recent movement in oil price can be attributed to OPEC, the global cartel of oil producing countries spearheaded by Saudi Arabia. OPEC countries account for about 40% of the world’s oil supply, although their market share is under threat from shale oil producers, particularly in North America. As oil prices fell in late 2014, OPEC chose to maintain production levels – a strategy to drive prices down and choke off competition from new shale oil producers.

Low prices have been painful for oil producing countries and Sunday’s meeting will discuss a production freeze. OPEC members will meet with important non-OPEC countries Russia, Oman and Bahrain in Doha in hopes of staving off further falls.

Oil prices have rebounded this week – a barrel of Brent Crude rose above $44 – its 2016 high. But further upward movement is by no means guaranteed. Oil rebounded after a sharp fall in 2009 but the recovery coincided with an OPEC production cut. This time round supply is not limited. Although globally the number of active rigs has fallen, oil reserves are rising in the US and OPEC has upped its output over the last year.

Dangers of Oil Exchange Traded Commodities

Exchange Traded Commodities (ETCs) are one of the most direct ways to invest in oil. ETCs track oil through futures derivatives, but this can be a costly way to invest. ETCs need to regularly sell maturing futures contracts and reinvest in new ones. This can cost the fund 10% per year on top of the ETC’s management expense ratio.

Some ETCs are leveraged – offering twice or three times the exposure to the oil movement, both positive and negative. So in theory if the oil price goes up 5%, your investment goes up 10% or 15%. Or if you bet in the other direction, if the oil price falls 5%, your investment likewise goes up 10% or 15%.

In this way leverage multiplies gains, but also multiplies losses if the oil price moves against you. Most leveraged ETFs are designed to be held for a short period of time, so holding for a long period of time when markets are choppy can produce negative results, because of the cost of rolling over the derivatives used to gain exposure. In the first six months of 2015, you would have made a loss on leveraged ETCs betting on a rising oil price and on a leverage ETC betting on a falling oil price, for this very reason.

London Stock Exchange’s most popular oil ETCs (2016 to date)

  1. ETFS WTI Crude Oil (CRUD)
  2. ETFS Brent 1mth (OILB)
  3. Boost WTI Oil 3x Leverage Daily ETP (3OIL)

Better ways to invest

Energy companies are a more simple way to gain exposure to oil. These companies’ revenues and profits are linked to the oil price, though the share movements have not been as extreme as the oil price. Investors in the likes of Shell or BP should hold these stocks as part of a diversified portfolio and make sure they are prepared to stomach price falls if the oil price lurches down again.

iShares Oil & Gas Exploration & Production UCITS ETF (SPOG)

This Exchange Traded Fund (ETF) has fallen almost a quarter over last year, but invests in almost 100 oil exploration companies globally. A risky choice, but could benefit if oil once again rises.

FTSE 100 shares: Legal & General UK 100 Index (Class C)

Mining and energy are important sectors for the FTSE 100. They account for roughly one fifth of the index, much higher than the global average, and are poised to benefit if the index rebounds. However the FTSE 100 is much wider than just these markets, including some companies who benefit from lower oil prices, which spreads the risk if current conditions persist.

Adam Laird is a senior investment analyst at Hargreaves Lansdown.

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