Should You Be Investing In Oil or Oil Stocks?

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Over the past decade oil has become a very popular investment theme as demand from China and India as well as other developing countries has pushed demand up to the available supply. At the same time innovative new products such as the Oil ETF have caused a sharp rise in investor demand. As with other commodities the weakness in the U.S. Dollar is the underlying factor that has caused a rise in oil prices over the past decade. Should you be investing in oil? If so, what is the best way to start investing in oil?

The primary reason you would want to invest in oil is because you believe oil prices are going to rise over time. Cash oil prices have risen from a low of $10.80 in December 1998 to a high of $145.66 in July 2008 so anyone who purchased it in 1998 could have made over 1000% return on the rise in oil prices. The problem with high oil prices is that it puts extreme pressure on consumers and slows the economy which in turn causes demand to fall along with prices. These swings in demand with a fairly constant supply cause prices to move quite wildly which can be seen on a regular basis. During the 2008 credit crisis oil prices fell from the $145 high all the way down to $30 per barrel in a 7 month period, so it’s not a market for everyone.

For the average person who wants exposure to oil prices, it’s probably a better idea to purchase a basket of oil stocks (using a oil stock etf) instead of buying the actual commodity (using futures or an etf). The reason being that oil stocks tend to be less volatile than the actual commodity, also if oil prices don’t rise but simply remain where they are today ( $80-$100 ) the oil companies will continue to pump out strong profits quarter after quarter so stock prices can continue to rise. If you look back at comparisons of the price performance between USO (the most popular crude oil etf) and XLE (the most popular Oil Stock ETF) you will see that XLE has strongly outperformed USO since it’s inception and this will most likely continue into the future.

If you intend to trade crude oil prices on a short term basis you may want to trade USO or the leveraged long version from ProShares (UCO). You can gain exposure to the downside as well by purchasing the ETF – SCO or the ETN – DTO which both designed to rise as the price of crude oil falls. Most of these financial instruments are designed for short term traders and do not work well for long term investors. For long term holding it’s hard to be the performance of XLE.

Michael R Peterson