How to Invest in Oil: A Beginner's Guide
Investing in oil isn’t everyone’s cup of tea, and that’s understandable given the history of oil stocks rising and falling.
Some of the wealthiest people in history, men like John D. Rockefeller, Jean Paul Getty, the Koch brothers, and many more, made their great fortune by investing in oil – black gold, Texas tea. But with oil prices plunging across the globe, investors today may be wondering, is now the right time to explore the energy sector and drill for undervalued investments?
After years of oil prices holding steady above $100 per barrel, prices declined sharply in 2014 and have failed to top $75 ever since. In 2020, a culmination of events, from a Saudi-Russia price war, to weakened global demand caused by the coronavirus pandemic, oil prices have once again plummeted.
Will we see another oil boom in our lifetime? Can investors find value in today’s low energy prices? This article will look at how to invest in oil and whether oil is a good investment today.
In This Article:
How Much Do I Need to Start?
Before you begin, let’s understand if you can even go there. Luckily, investors can start investing in oil with as little as $1,000 in a trading account at an online brokerage, like Questrade. From there, they’d need to decide whether to invest in individual stocks, or in an oil ETF. Personally, with little money to invest in oil, I’d opt for an ETF to diversify my investment and get exposure to more oil companies.
Don’t put all of your eggs in the oil & gas basket. Start with a small investment to see how it performs and also to see how you behave as an investor with a volatile portfolio like oil.
Why Invest in Oil?
It wasn’t long ago that oil companies like Exxon and BP were some of the most valuable businesses in the world. That changed when oil prices plunged in 2014, and investors who bought into that oil crash have largely been disappointed. But oil prices fell again in 2020, briefly dipping into negative territory, and potentially unearthing some rich opportunities for investors.
Despite the recent turmoil, oil stocks have indeed generated an enormous amount of wealth for long-term investors, both through capital gains and dividends. Canadian oil giants Suncor (SU) and Canadian Natural Resources (CNQ) stock briefly flirted with prices not seen since 2005. But, since 1995 Suncor stock has grown by more than 1,100% and Canadian Natural Resources stock has grown by more than 1,500%. That’s a compound annual growth rate of 10.48% and 11.94% respectively.
Besides, there’s plenty of life left in the oil business – with more than 47 years of oil on reserve based on current levels of global demand and consumption.
Oil Stock Prices
The fate of oil & gas companies is directly linked to crude oil prices – or more specifically the price of a barrel of oil. The benchmark index most widely used to measure oil prices is known as West Texas Intermediate, or WTI.
When oil prices are booming, and WTI is trading at more than $100 per barrel, oil stocks surge higher. These booms most notably occurred during the late 1970s and early 1980s, and again from 2007-2008, with the barrel of oil reaching an incredible $164 per barrel.
But, like most boom and bust cycles, oil stocks plummet when the price of oil crashes. The mid-1980s saw oil prices fall to just $25 per barrel, while a prolonged crash in the mid-to-late-1990s saw oil prices hit a low of $17 per barrel.
Oil prices have always managed to find their way to new heights, eventually. Today’s oil crisis may be no different. After touching $18 per barrel in April 2020, oil prices have recovered somewhat to $33 (as of May 2020).
The Best Strategies to Invest in Oil
When I was a new investor in 2010, I was enamoured with Canadian dividend paying stocks and that approach led me to owning shares in several individual companies in the oil & gas sector – including blue chip stocks like Canadian Natural Resources and Suncor. Fast forward to 2015 and those stocks were down more than 30% from my original purchase price.
I ended up selling those investments, along with the rest of my individual stocks, and switching to index investing with ETFs. But savvy investors looking to profit from a potential oil market rebound could find great value investing in individual oil stocks.
Invest in Individual Oil Stocks
Yield hungry investors look for stocks that pay an attractive dividend, and three oil stocks that fit the bill include:
- Canadian Natural Resources – 7.09% dividend yield
- Suncor (SU) – 3.67% dividend yield
- Enbridge (ENB) – 3.24% dividend yield
The challenge with hunting for yield is that dividends are often at risk of being suspended, cut, or eliminated during challenging economic times. It might be better for investors to hunt for value using a classic value screen known as the price-to-book ratio – where a low ratio is seen as beneficial. Three new stocks emerge:
- Teck Resources (TECK-B) – 0.31 price-to-book
- Cenovus Energy (CVE) – 0.36 price-to-book
- Imperial Oil (IMO) – 0.63 price-to-book
All three stocks have one thing in common – they’re all down more than 44% in the last year. But if the market has unfairly punished these three oil companies, investors might find great value here as they look to capitalize on a potential recovery.
Pro Tip: The best way to buy individual stocks is through a discount brokerage, and if you don’t want to pay expensive trading fees every time you buy and sell you’ll want to go with Questrade, one of our top online brokerage choices.
Invest in Oil ETFs
Picking individual stocks can be risky and so a smarter and more diversified approach to investing in oil might be through an oil ETF.
An ETF is a collection of individual stocks in a particular sector, country, or region. They offer investors diversification at an affordable price. It lowers the risk of investing in any one individual stock that may decline in value or even go out of business.
Here are the top oil ETFs trading in Canada:
- iShares S&P/TSX Capped Energy Index ETF – XEG – This ETF holds 22 companies in the Canadian energy sector and has net assets of more than $592 million under management. The ETF price is trading at only $4.95 as of this writing (May 15) – a reflection of the nearly 50% decline in price in the past year. The management expense ratio (MER) is 0.61% and the ETF pays a juice dividend yield of 5.65%.
- BMO Equal Weight Oil & Gas Index ETF – ZEO – This ETF holds just 11 Canadian large-cap oil and gas stocks. It takes an “equal weight” approach, meaning each company makes up an equal share of the overall portfolio. This is different from a market cap-weighted approach (like XEG takes) where the larger companies make up a greater proportion of the portfolio. ZEO has $123 million in assets under management, comes with an MER of 0.61%, and pays a dividend yield of 6.10%.
- Horizons S&P/TSX Capped Energy Index ETF – HXE – This ETF tracks the S&P/TSX Capped Energy index which tracks 22 Canadian energy companies. It has $17 million in assets under management and comes with an MER of 0.28%. The advantage of HXE is its unique corporate class structure, which does not pass along taxable distributions directly to shareholders – making this ETF particularly attractive in taxable accounts.
Recommended Read: Best ETFs in Canada.
Trade Commodities or ETFs
Investors can also trade oil futures (commodities) or even other ETFs that follow the global oil market prices. Beware, some of the more exotic leveraged ETFs can quickly get an investor into hot water.
Horizons offers a suite of ETFs that provide leveraged, inverse, and inverse leveraged exposure to different equity and commodity indices. They’re aimed at savvy investors looking to take on additional risk in their portfolio, but in reality, investors would have to be crazy to trade these products.
- BETAPRO S&P/TSX Capped Energy 2x Daily Bull ETF – HEU – This ETF seeks daily investment results that aim to correspond to two times (200%) the daily performance of the S&P/TSX Capped Energy Index. It uses leverage which can amplify returns, both positive and negative. The year-to-date performance has been -81% as oil prices plummeted.
- BETAPRO S&P/TSX Capped Energy 2x Daily Bear ETF – HED – This ETF seeks daily investment results that aim to correspond to two times (200%) the inverse (opposite) of the daily performance of the S&P/TSX Capped Energy Index. It uses leverage, but its results aren’t perfectly correlated with the market and therefore its performance is up only 35% year-to-date.
- Horizons NYMEX Crude Oil ETF – HUC – This ETF tracks the performance of NYMEX light sweet crude oil futures contracts and comes with an MER of 0.87%.
- United States Oil Fund LP – USO – This ETF tracks the West Texas Intermediate (WTI) benchmark and comes with an MER is 0.79%.
Possible Risks and Rewards of Investing in Oil
Depending on your worldview, investing in oil could once again lead to tremendous gains, or it could be a dying industry making way for a new green energy movement.
The upside is clear. With several decades of oil reserves in the ground, and still sustained global demand for oil in both emerging and developed markets, investing in oil means betting on at least one more boom in the oil cycle.
The risks are also clear. The future of oil is at a crossroads. Oil prices crashed in 2014-15, and then crashed again in 2020. There’s no guarantee that oil will bounce back, and if that’s the case then investors face years of sideways price movements at best, or an investment that will go to zero at worst.
Dos and Don’ts of Investing in Oil
By now should know that investing in oil is like a roller coaster ride of stomach-churning highs and lows. If you want in on the oil & gas ride, here’s what you need to know:
Do invest in blue-chip oil & gas companies who have the appropriate size and balance sheet to weather the boom and bust cycle.
Don’t bet on junior oil & gas companies (penny stocks) that are heavily indebted or simply don’t have a proven track record.
Do invest broadly with an oil & gas ETF to capture the performance of the entire industry and diversify your risk.
Don’t invest in complicated leveraged ETFs or more volatile commodity ETFs that magnify your gains and losses as oil prices move up and down.
Is Oil a Good Investment Today?
Classic value investors like Warren Buffett look for stocks or sectors that have been beaten up over time and perhaps unfairly valued compared to their future prospects. One could easily make that argument for the oil & gas sector right now as oil prices fell sharply for the second time in six years.
If oil has one more boom left in it then investors could do well by investing in oil at today’s lows.
On the other hand, decreasing global demand for oil, coupled with rising demand for green energy alternatives may have spelled the end of the oil & gas industry. We may be stuck with low oil prices for years – making it difficult for the sector to thrive again.
No one knows what the future holds. There’s a good chance we’ve seen the last of oil stocks leading the world in market value, but at the same time companies are constantly innovating and finding new ways to profit.
If you’re unsure or want an extra set of eyes looking at your portfolio and checking to see when it would be best for you to pick up an oil stock or trade an ETF, online brokers are a great tool to use to have you at peace with the investment moves you’re making.
While I wouldn’t put my retirement fund into the future of oil & gas, I could live with betting 5% of my portfolio on the energy sector to see if it comes to life again.