In this article, we answer the 11 questions that are commonly asked about investing in oil as an asset class. The goal is to provide a quick, simple and only-what-you-need-to-know background to fast-track your knowledge about investing in oil. We summarise the article by reviewing the latest development in the oil market.
Otherwise, let’s sprint.
1. What are the different types of oil?
The two main benchmarks for oil prices are Brent Crude and West Texas Intermediate (WTI). These are known as conventional oil. In particular, Brent is used to set the price of two-thirds of the world’s internationally traded crude oil supplies.
2. What are the differences between Brent and WTI?
Both Brent and WTI are described as “light” and “sweet” because of its relatively low density and low sulphur content, respectively. Otherwise, the key differences are as follows.
3. What is shale oil and why should I care?
Shale oil is crude oil produced from shale rock via hydraulic fracturing or fracking. This is important because it can act as a substitute, hence, lowering demand for conventional. You can learn more about fracking here.
Extracting shale oil can be more costly than conventional, which in the current oil market rout, means that shale oil firms are experiencing prices way below its cost of productions.
So, why bother producing shale oil when conventional is cheaper? Politics.
Over the years, the US government has provided its oil shale industry with layers of subsidies. However, this is more challenging situation today with conventional oil trading where they are.
4. What is OPEC?
The Organization of the Petroleum Exporting Countries (OPEC) is a 13-nation body that aims to coordinate and unify petroleum policies of its members. Consequently, the goal of OPEC is to ensure stabilisation of the oil markets through coordinated oil production levels among members.
The latest data shows that, 79.4% of the world’s proven oil reserves are located in OPEC Member Countries. As a result, OPEC has a major influence on global oil prices.
5. Who are the top oil producers and consumers?
6. What is an oil future and how does it work?
An oil future is an obligation to deliver (buy or sell) oil at a specific price, amount and time. The vast majority of future contracts are closed out before the expiry data and don’t lead to delivery.
Futures are normally traded on an exchange, for example, Brent on ICE (Intercontinental Exchange) and WTI on NYMEX (New York Mercantile Exchange). Interestingly, oil is an asset that produces no income but incur storage cost up till delivery. Consequently, the concept of storage cost will come in handy later when we explore why WTI briefly turned negative.
7. What are the key drivers of oil prices?
The three key drivers of oil prices are
- Demand: Global growth, economic activity and substitutes such as shale oil or renewable energy.
- Supply: The level of oil reserves, largely driven by OPEC members.
- Geopolitics: Also known as petroleum politics. Whenever there’s a tension / crisis in an oil producing country, oil prices tend to shoot up driven by fear of decreased supply.
An interesting chart highlighting the importance of geopolitical risks to oil prices.
8. How to invest in oil?
In general, these are one of few key ways to invest in oil, direct or indirectly.
- Oil futures / options
- Exchange-traded funds
- Oil related stocks
For oil related stocks, there are three main sectors:
- Upstream: finds and produces crude oil and natural gas. Also known as exploration and production (E&P) companies.
- Midstream: transportation, storage and marketing of oil related products.
- Downstream: refining of crude oil and the processing and purifying of raw natural gas.
Integrated oil and gas companies are involved in the entire value chain of the oil business. For example, Exxon Mobile (XOM).
9. The relationship of oil prices
There're many causal-effect relationships between oil prices and various asset classes over time. We highlight the two we find most intuitive.
Historically, commodity prices tend to move in opposite directions with the dollar. Oil is no exception. A stronger USD means that a barrel of oil now cost more, hence, potentially decreasing demand for oil, and vice-versa.
Oil plays an important part of most inflation measures such as consumer price index (CPI). Accordingly, an increase in oil prices tend to lead to an increase in inflation. The converse is generally thought to be less clear.
10. What caused WTI to trade at negative territory?
On 20th April 2020, the WTI May 2020 contract traded as low as -$37.63 a barrel. That’s right, you get paid from buying oil!
To understand this, we need to go through the concept of a future contract (if you forget, click here). Each month, WTI contracts needs to be settled on physical delivery of crude oil. To facilitate, storage is required. With the coronavirus crisis in full swing, demand for oil cratered, hence, more barrels are stuck in storage.
As a result, scarcity of storage space. This caused panic in the market, driving down prices to negative territory. Imagine if 1,000 barrels of oil turns up in front of your residence tomorrow!
The latest data from EIA shows that tanks were already housing 55m barrels of oil, or 72% of working storage capacity. To make matters worse, the remaining capacity may be unavailable to those who had not leased it earlier.
A negative price means that holders are willing to pay for you take stocks out of their hands. To put it simply, the cost of storage is more than the value of oil today.
11. What are the impacts of prolonged low oil prices?
Shale oil industry
It is said that shale oil companies are not economically viable when Brent falls below the $50. At the time of writing, it’s trading at ~$20. With a higher production costs due to fracking, we are seeing companies drastically cutting production or even shutting down operations.
In fact, Whiting (WLL) became the first US shale company to file for Chapter 11 bankruptcy on 2nd April 2020. Many argue that this is just the “first domino” to fall in the US shale wipeout.
Upstream companies operates a capital intensive business as it involves exploration and production of oil. Accordingly, costs of production is largely fixed. For this reason, the more oil it produces, the more losses they may incur. It follows that the main players have already began to cut production.
Unlike upstream companies, downstream companies are involved in the petroleum refining process. With crude oil as an input, it’s clear to see how they benefit from a lower cost of production. On the other hand, they may see a fall in demand for petroleum products.
In summary, investing in oil requires an appreciation of oil economics and the understanding of the current geopolitical climate.
Let us know what area you would like to explore more below in the comments.