As a rule, novice retail investors believe that investing in oil requires a lot of capital. In their minds, such investments require the establishment of their own oil production or refining company. This, in turn, involves acquiring land, purchasing, transporting and installing equipment, and hiring workers.
Of course, such an oil business can be very profitable, but it also turns out to be very costly and time consuming. However, today’s financial markets offer much easier and faster ways to invest in oil. Experts highlight several affordable investment options that can provide good returns in the future.
These include:
- trading in settlement price futures;
- investing in ETFs or mutual funds that work with oil indices and futures;
- buying shares of companies from the oil sector that are freely traded in the markets;
- purchasing structured financial products with appropriate underlying assets.
Oil futures
Working with derivative instruments on the derivatives market, such as oil futures, has become an obvious choice for retail investors wishing to invest in this commodity asset.
This market offers settlement (non-deliverable) futures for Brent crude oil. The standard volume of the contract is 10 barrels, and prices are specified in US dollars per barrel, with settlements made in roubles. To open a position, a security deposit of approximately 10 thousand rubles is required (with slight variations depending on the specific contract).
Investors using this instrument should keep in mind some important nuances
- Collateral Assurance (CA) is a mechanism for making unsecured (margin) transactions. As a result, the price of the contract is relatively low, and its purchase (or sale) becomes available to almost everyone.
- Nevertheless, leveraged trading involves a high level of risk, and losses of traders may not be limited. Therefore, it is recommended that transactions on the derivatives market be conducted only after a thorough study of the specifics of the contracts, as well as a full understanding of their mechanisms and associated risks.
- Variation margin is charged or deducted during each clearing session and account reserves are required to meet margin requirements. Although futures prices generally follow the movement of the underlying asset (e.g. oil prices), their volatility is higher, which increases the level of risk.
- Futures are futures instruments that last for a set period of time. For medium and long-term investments, it is necessary to independently transfer the invested funds from contract to contract after expiry.
- Futures can be bought or sold, which allows you to open short positions without unnecessary actions. It is possible to close a position at any time by making a reverse transaction.
- The liquidity of contracts with different expiry dates varies, and it is most profitable to use futures expiring at the beginning of the next month.
Retail unqualified investors need to be tested by a broker to gain access to instruments in the derivatives market. Some brokers may conduct tests not only for futures and options, but also for unsecured margin transactions.
In general, it is not advisable to consider oil futures as a long-term investment instrument. It is better to use it for short-term speculative profits or as a hedging tool.
It is important for a novice investor to limit the volume of trading with this instrument to 2-5% of the total investment capital. When trading oil futures, it is mandatory to set protective stop losses to control the level of losses according to the terms of your investment strategy.
Oil ETFs and mutual funds
One way to invest in oil is to purchase funds (ETFs or mutual funds). Most of them use oil futures as the underlying asset. In this way, the investor gets an asset with similar characteristics as when trading futures. However, funds have their own advantages:
- No maturity restrictions, as the issuer automatically manages transitions between contracts.
- No leverage, which significantly reduces risk, although it also results in lower potential returns.
For novice investors in ETFs and mutual funds, it is useful to know the following:
- At the moment, oil funds are not represented on Russian stock exchanges. Some of them are available on the St. Petersburg Exchange in the OTC format, but their purchase requires the status of a qualified investor.
- Oil ETFs can be purchased on international trading platforms. This requires opening an account with a broker that provides access to both Russian and foreign markets, or contacting a foreign brokerage company.
- The profitability of ETFs can be reduced not only due to the lack of leverage, but also due to the management company’s commission, which is usually around 1%. To take a short position on the underlying asset, you can use ‘inverse’ ETFs that profit when oil prices fall.
In general, for the retail investor, oil ETFs may present a more attractive option compared to trading futures. However, at the moment, direct access to these instruments for Russian investors is rather problematic.
Structural financial instruments
Structured financial instruments designed for investing in oil are securities (mainly bonds) issued by both Russian and foreign companies, the payments on which depend on fluctuations in oil prices.
To successfully work with such instruments, a novice investor should:
Analyse the prospectus, paying special attention to the terms of payments. Some companies set strict requirements, which in practice remain practically impossible to fulfil (for example, the need for oil quotations to grow for six consecutive months).
Evaluate the credit ratings of the issuer that issued the securities, as well as the guarantor. It makes sense to consider such products only if the ratings are high enough (ideally, investment grade ratings should be chosen).
Focus on investment products that offer partial or full return of capital (full return is preferred).
Shares of companies in the oil industry
In fact, when an investor buys shares in oil companies, he is investing in the oil business, not just in the value of oil. His income, whether from dividends or speculation, ultimately depends on the world prices of this resource. However, it is worth noting that the value of shares depends not only on the quotations of oil contracts, but also on many other factors, such as:
- The quality of the company’s management;
- country of incorporation;
- production costs, etc.
Therefore, the approach to selecting an investment object should be carefully considered. It is important to analyse the financial statements of the company, to determine the indicators for the shares. Also of great importance are the distribution of profits, stability and size of dividends.
For such investments, the optimal solution will be companies that are among the leaders in the stock markets. Russian investors are not hindered by this method, as many issuers from the oil sector are included in the list of blue chips on the MOEX. They are the ones you should focus on first.
Diversification of investments should not be neglected – distribution of funds between different issuers can significantly reduce risks if some companies have problems. For this purpose, it is worth considering buying shares of companies from different countries, which are traded in different currencies, etc. However, this approach may require a significant investment of capital.
Useful tip: In order to achieve the maximum level of diversification with minimal investment, it is worth paying attention to funds specialising in shares of oil companies. However, there is nothing stopping you from looking for a suitable ETF on foreign exchanges, for example, on American ones.
Bottom line
Investing in oil can be lucrative, but it also comes with risks. Here are some tips for beginners:
- Study the market: Before you invest, familiarise yourself with the basic principles of the oil market, trends and factors affecting prices.
- Diversify your portfolio: Don’t invest all your money in one company or asset type. A variety of investments will help reduce risk.
- Choose a reliable broker: Go with a trusted and licensed broker who can help you make trades in the oil market.
- Follow the news: Keep abreast of economic and political events that may affect the oil market.
- Use analytical tools: Apply technical and fundamental analysis to make informed decisions.
- Start small: Do not invest large sums of money right away. Start with small investments to understand how the market works.
- Consult experts: If you are not sure of your knowledge, consult financial advisors or experienced investors.
- Be patient: Don’t expect instant profits. Investing in oil takes time to achieve significant results.
- Research the risks: Understanding the potential risks will help you make more informed decisions.
- Keep your knowledge up to date: Keep learning and keeping up with new trends and developments in the oil industry.
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