Oil is still an essential resource for our standard of living. While efforts are being made to move away from fossil fuels, renewable energies will take a long time. We discuss the opportunities and risks of investing in oil in 2023.
- Risks of Investing in Oil
- How to Invest in Oil
Our world remains highly dependent on oil. Although its importance has decreased significantly since the decade of the 1970s, the truth is that our current lifestyle would not be possible without abundant and affordable energy, some of that being oil.
Despite all this, oil has always been a somewhat complex asset to invest in. This is because there are many variables at play and these are difficult to predict, such as geopolitical risks, the future of the world economy, the discovery of new deposits and the role of OPEC in the world.
Until relatively recently, oil was considered the black gold of the world economy. It is certainly something that has made many countries of the world rich, especially in the Middle East. Although to other countries having oil reserves turned out to be a curse in the long run, such as in Venezuela.
At present, however, many Western countries are making great efforts to reduce their oil consumption. In addition to economic and geostrategic issues, topics such as climate change and the goal of reducing carbon dioxide emissions have to be considered from now on.
New financial regulations are having a very significant impact on the way the sector works around the world. For example, whether oil producers are able to raise capital from investors to develop new production very often comes down to government regulation and financial policies.
In such a scenario many investors wonder if investing in oil is still a good idea in the 2020s. With the goal to answer this question, we will do an in-depth analysis of the opportunities and risks of investing in oil:
Let us first discuss the reasons in favor of investing in oil:
Essential Energy Source
First of all, and this is something we have already alluded to in the introduction, our current lifestyle could not be sustained without oil. While it is something we give for granted, life would be so much more difficult if access to oil was banned or even limited.
The relative high standard of living enjoyed by the average citizen in developed countries would be impossible without the key role that this energy source plays in the world. So, rather than simply criticize the consumption of oil, we should understand what oil does for us.
Thus, regardless of the efforts being made in energy, economic, financial and environmental policies, the fact remains that demand for oil from the developed world will remain high for a long time to come.
And the growth of many emerging economies, especially in countries like India, means that global demand is likely to increase over the next few decades.
Western Policies aiming at Reducing Oil Production
I know this may sound surprising to many, but Western policies that are designed to curtail to production of oil can be positive for those investing in oil.
In certain regions of oil-producing developed countries, governments are increasingly making it difficult, if not outright impossible, for corporations to develop new oil wells.
This results in a reduction of the supply of oil in the world. And the lower the supply, the higher the price. In fact, there are many investors who believe that it is precisely these types of policies that can bring the price of oil to stratospheric levels before the decade is over.
In most free markets when the price of a product rises substantially, there are more incentives to increase production. That causes prices to moderate. But in the current regulatory framework many countries would be incapable of increasing their production. Therefore, if oil prices go up significantly, they are likely to remain elevated.
Consequently, regulation may lead to a surge in the profits of many oil companies. That will happen at the same time that the cost of living for the average citizen increases, potentially leading politicians to take even more measure against the industry that will deepen the supply issues even further.
At the macroeconomic level, there is no doubt that we live in times of high monetary policy uncertainty, lack of fiscal discipline and excessive public and private debt. These factors point to a high risk of inflationary pressures in the coming years.
When the price of everything increases, due to a reduction in the value of money, capital tends to flow into real assets. These are things whose value does not depend on the health of the monetary system. And commodities are one of the best examples of real assets.
If we look at what has happened throughout history, we will realize that the price of natural resources and of companies producing them, tends to increase dramatically in highly inflationary times.
As a result, investing in oil can not only protect us from the harmful effects of inflation, but even make it possible for us to benefit from them.
Related to the previous point, investing in oil will make our portfolio better prepared for a greater variety of macroeconomic scenarios that could occur in the future. Especially those that lead us to stagflation, that is, a world of low economic growth and high inflation.
The portfolio of many investors today has a very large exposure to assets that need low inflation rates and even lower interest rates. Without those conditions, these investment portfolios would suffer.
Investing oil translates into having assets capable of doing well in an inflationary scenario, thereby increasing the degree of diversification in our portfolio.
ESG Policies and Guidelines
Investing in ESG products refers to the preference of some investors, particularly institutional ones, such as pension and investment funds, as well as regulators, to invest money based on environmental, social and governance criteria. If you want to learn more about the subject, check out my analysis on the subject.
One of the consequences of such a phenomenon is that some sectors become uninvestable for many investors. Consequently, even if some of these investors wanted to put money into the oil business because of the potential returns, they could not.
A smaller number of potential investors leads to artificially low prices. And that presents a golden opportunity for those investors who can buy those assets.
In that sense, we could end up in a situation similar to what we have experienced with tobacco companies, which have been both unloved and uninvestable since the 1990s. Coincidentally, it is one of the sectors that has achieved the highest returns over the last three decades.
Risks of Investing in Oil
Next, we discuss the largest risks of investing in oil:
Alternative Energy Sources
Although the world remains heavily dependent on oil, it is undeniable that alternative energy sources are being developed and improved. They are increasingly efficient and economical.
While oil has unique characteristics can probably never be completely replaced, that does not mean that a relative decrease in its importance would not affect its price and the oil sector as a whole.
Although we are still a long way from being in that situation, it is something that we must bear in mind when investing our money in the oil sector.
The development of these alternative energies is driven by government policies aimed at reducing oil consumption in the long term.
And although our standard of living in developed countries is dependent on oil, many governments are already showing their cards: they are willing to force a lower standard of living on their citizens if they succeed in advancing their energy policy objectives.
One of the consequences of such actions would be a significant drop in oil demand in the future, which would not be positive for the sector.
If there is a product that perfectly embodies the will of many countries to reduce oil consumption in the future, it is the electric car. After all, personal mobility is one of the biggest uses of oil today.
Therefore, if the fleet of cars in many countries becomes mostly electric, the demand for oil will be reduced. Without getting into questions about the sustainability of the power grid, that would be bad news for the oil sector.
If you want to combine your investment in oil with another investment that could benefit from the success of the electric car in the future, without having to invest in car manufacturers like Tesla, you can take a look at this analysis: Investing in Lithium – EV Commodity Trade
Political Risk in the West
This last point is mostly relevant for those companies that run most of their oil extraction and refinery operations in Western countries.
It could not be ruled out that some Western countries, eager to push their energy and environmental agenda, completely banned oil production in their country.
That would be similar to the nationalization of a gold mine by a government, in terms of the impact it would have on shareholders. Those companies would be stripped of their assets and suffer substantial losses. This would be the extreme version of what has been happening gradually for a few years.
To reduce that risk, we would need to pay attention to the jurisdictions in which the companies run their operations. After all, it is highly unlikely that countries such as Mexico, Brazil or Saudi Arabia, whose economy depends on oil exports, would ever implement such measures.
How to Invest in Oil
There are several options available for those who want to invest in oil:
Oil Producers ETF
The easiest way to gain exposure to the sector would be by investing in an ETF of oil companies. This would be a very diversified way of investing in oil, since we would own companies active in the entire production chain: exploration, extraction, refinement, distribution, etc.
An example would be the XLE ETF, managed by State Street and intended to track the energy sector of companies in the US S&P 500 index.
One of the disadvantages of investing in an ETF of oil companies is that most of them would are located in developed countries, meaning we would be more exposed to future regulations by those governments.
Shares of individual Oil Companies
We can also directly buy shares of companies in the oil sector. This would give us a lot of flexibility and the option to analyze and choose what companies we would like to own.
For example, we could invest in the oil majors in the United States, such as Exxon or Chevron, smaller US corporations, such as Occidental Petroleum, large European companies, such as BP, Royal Dutch Shell, Total or Repsol, or those of emerging countries, such Petrobras or Saudi Aramco.
Physical Oil ETF
Finally, if instead of investing in companies in the oil sector, we only want to invest in physical oil, it is also possible to do it from the comfort of our home, and without having to get into trading futures, something that, while possible, would be about trading oil and not investing in it.
There are ETFs that simply invest in oil futures contracts for us, so that we do not have to worry about margin, leverage and large investment amounts.
An example would be the WisdomTree WTI Crude Oil ETF, which tracks the price of a barrel of WTI oil in the United States. For those who would like to track the price of Brent oil, listed in London and the main reference for the European market, they can check out the WisdomTree Brent Crude Oil ETF.
Oil is by no means one of the investment community’s favorite sectors, as it once was. However, this does not mean that investing in oil is not going to be profitable. In fact, it could turn out to be fantastic.
Remember that large profits are achieved when we invest in something that many people believe has no future. Oil certainly fits that description.
Throughout this post, we have analyzed the consequences of the energy policies that are being implemented in many countries in order to reduce oil consumption. As we have seen, they represent a big risk but also create potential opportunities.
Finally, I would like to add that my goal is not to provide investment advice, but simply give you useful information, so you can take your own decisions.
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