A Guide to Oil ETFs: Everything You Need to Know

Oil is one of the most significant resources in the global economy. However, investing directly in crude oil can be complex. 

This is where Oil ETFs come into play. Oil ETFs offer a convenient and accessible way for individuals to gain exposure to oil prices.

This guide will walk you through the essentials of investing in oil ETFs, including the benefits, risks, types of oil ETFs, and strategies to help you make an informed decision.

What Are Oil ETFs?

An oil ETF is an exchange-traded fund that aims to track the price of oil. Oil ETFs give investors the opportunity to:

-Gain exposure to oil prices without trading futures directly

-Diversify their portfolios with an asset class that behaves differently from stocks and bonds

-Capitalize on price swings driven by geopolitical events, production cuts, or demand spikes

Oil ETFs can sometimes also refer to stock ETFs that hold baskets of oil companies. These are different than oil futures ETFs, and we will touch on these funds in this guide as well. 

Why Invest in Oil ETFs?

Oil ETFs provide exposure to the oil market without the need for a commodities trading account or direct interaction with oil futures. Here are a few reasons why investors might consider oil ETFs:

• Convenience and Liquidity: Oil ETFs trade on major exchanges like stocks, making them accessible to anyone with a brokerage account. This provides liquidity and ease of trading, even for small-scale investors.
• Diversification: Adding oil to a diversified portfolio can provide a hedge against inflation and protect against currency fluctuations. Oil prices tend to increase when inflation rises, making oil ETFs a potential inflation hedge.
• Volatility and Speculation: Oil is known for its price volatility due to geopolitical issues, natural disasters, and changes in production. This can create opportunities for short-term gains, making oil ETFs appealing to speculators.
• Lower Costs: Compared to purchasing oil futures directly, oil ETFs have lower entry and transaction costs, making it more affordable for the average investor.

Types of Oil ETFs

Oil ETFs come in various forms, each offering unique exposure to the oil market. Understanding these types can help you choose the most suitable option for your investment strategy.

Futures-Based Oil ETFs

Futures-based oil ETFs, like the United States Oil Fund (USO), track the price of oil by investing in futures contracts. These contracts are agreements to buy or sell oil at a specific price on a specific date in the future. When the contract approaches expiration, the ETF sells it and buys another one further out, a process called “rolling over.”

• Pros: Futures-based oil ETFs are usually more closely correlated with the spot price of oil, making them ideal for investors looking for short-term exposure to oil prices.
• Cons: Due to “contango” (when future prices are higher than the spot price), these ETFs can suffer from “roll yield” losses when they roll contracts at a higher price than the current one.

Leveraged Oil ETFs

Leveraged oil ETFs, such as the ProShares Ultra Bloomberg Crude Oil (UCO), use financial derivatives to amplify their returns by 2x or 3x. These funds aim to provide multiples of the daily performance of the oil price or futures contracts they track.

• Pros: Leveraged ETFs can provide substantial short-term gains during periods of significant price movement, appealing to high-risk traders.
• Cons: Leveraged ETFs reset daily, which can lead to compounding effects and significant losses if held for more than a day, especially in a volatile or sideways market. They are generally not recommended for long-term holding.

Inverse Oil ETFs

Inverse oil ETFs, like the ProShares UltraShort Bloomberg Crude Oil (SCO), aim to deliver the inverse performance of the price of oil, typically on a daily basis. These ETFs can be a good option for investors looking to profit from a decline in oil prices without short-selling futures.

• Pros: Inverse oil ETFs provide a simple way to short oil prices without complex trading setups.
• Cons: Similar to leveraged ETFs, inverse ETFs reset daily, making them better suited for short-term trading rather than long-term investments.

Equity-Based Oil ETFs

Equity-based oil ETFs, like the Energy Select Sector SPDR Fund (XLE), invest in a portfolio of oil stocks, including exploration, production, refining, and distribution companies. This means that their performance is not directly tied to oil prices, but rather to the performance of these companies, which can be influenced by both oil prices and other factors like growth and profitability.

• Pros: Less exposed to the issues of contango, making them more suitable for long-term investors.
• Cons: Equity-based oil ETFs are influenced by both oil prices and the financial health of the companies within them, making them less sensitive to immediate price swings in the oil market.

Key Risks of Investing in Oil ETFs

While oil ETFs offer unique opportunities, they come with several inherent risks that investors should be aware of before investing.

Market Volatility

Oil prices are notoriously volatile, affected by a wide range of global factors such as OPEC production cuts, geopolitical tensions, and changes in demand. As a result, oil ETFs can experience sharp price swings, creating a challenging environment for inexperienced investors.

Contango and Backwardation

Futures-based ETFs are subject to contango and backwardation, two market conditions that can impact returns. In contango, future prices are higher than current prices, which means an ETF buying higher-priced contracts could erode returns. In backwardation, future prices are lower than current prices, which can be beneficial for the ETF as it rolls contracts at a discount.

Decay in Leveraged and Inverse ETFs

Leveraged and inverse ETFs often suffer from value decay over time due to their daily resets. As these ETFs are structured to match daily rather than long-term movements, they are not suitable for buy-and-hold strategies.

Regulatory Risks

Governments around the world play a significant role in regulating oil production and trading. For instance, regulations restricting drilling or increasing taxes on oil can impact the supply and cost, indirectly affecting oil ETFs. Understanding the geopolitical and regulatory environment is essential for anyone considering oil ETF investments.

How To Invest in Oil ETFs: A Step-by-Step Guide

Investing in oil ETFs is similar to buying stocks and involves selecting an appropriate broker, researching ETFs, and setting your investment goals. Here’s a step-by-step approach to get you started:

Step 1: Choose a Brokerage Account

Start by selecting a brokerage account that offers a wide range of ETFs. Ensure the broker provides easy access to the ETFs you’re interested in and offers reasonable trading fees.

Step 2: Define Your Investment Goals

Identify whether you’re seeking long-term exposure, a hedge against inflation, or short-term speculative opportunities. Your goals will determine the type of ETF that best fits your strategy. For example, if you’re interested in short-term gains, a leveraged or futures-based ETF may be ideal. Conversely, if you’re aiming for long-term exposure, an equity-based oil ETF could be more suitable.

Step 3: Research Different Oil ETFs

Explore the different oil ETFs available and consider factors such as expense ratios, trading volume, and structure (futures-based, equity-based, etc.). Review the ETF’s historical performance, fees, and management strategy to assess how well it aligns with your investment objectives.

Step 4: Monitor Oil Market Trends

Keeping track of the broader oil market and understanding factors that influence oil prices, such as supply and demand dynamics, geopolitical events, and regulatory changes, can help you make informed investment decisions. Financial news websites, analyst reports, and economic data from the U.S. Energy Information Administration (EIA) provide valuable insights.

Step 5: Make the Investment

Once you have researched and chosen an ETF, proceed to buy shares through your brokerage account. Determine whether you’ll use a market order (which executes immediately at the current price) or a limit order (which only executes if the price meets your specified target).

Strategies for Investing in Oil ETFs

There are several strategies investors can use to capitalize on oil ETFs. Here are three commonly used ones:

Buy-and-Hold Strategy

For those who believe oil prices will rise over the long term, a buy-and-hold strategy using equity-based oil ETFs can offer exposure to oil without worrying about contango. This approach is more suitable for long-term investors interested in capturing the potential growth of oil and gas companies.

Short-Term Trading Strategy

Investors looking to take advantage of oil price volatility may consider futures-based or leveraged oil ETFs. However, this approach requires closely monitoring the market and understanding how to respond to short-term trends.

Hedging Strategy

Investors who own oil-related assets (such as stocks in the energy sector) may consider using inverse oil ETFs to hedge against potential losses if oil prices decline. Futures-based oil ETFs could also be used to hedge against geopolitical risks. 

Bottom Line on Investing in Oil ETFs

Oil ETFs offer a unique investment opportunity for those looking to participate in the oil market without the complexities of futures trading. While they provide easier access to the benefits and risks associated with oil prices, understanding how they work is key.