How to bet on the oil price

by , 24th July 2018

Oil prices are back in the news in a big way, having enjoyed hefty gains in the past year or so. Can they keep rising from here? Or are we heading for another crash? And what does that mean for your investments?

First, let’s have a quick summary of the rollercoaster ride that oil’s been on over the past five years or so. In 2014, after several years of coasting around the $100 a barrel mark, the oil price finally gave way to the inevitable and crashed. Investors had realised that US shale oil production was booming, and that the US was on the road to becoming, for all intents and purposes, energy independent.

The price tumbled to as low as below $40 a barrel. Oil majors slashed production and exploration spending, shutting down ambitious projects for seeking oil in faraway, inhospitable, expensive climes, in favour of conserving as much cash as possible to pay their all-important dividends.

Yet oil cartel Opec continued to pump out oil as fast as it could. The cartel members didn’t want to run the risk of losing market share to US shale producers, and they were also hoping to put the shale fields out of business by driving the price well below the cost of production.

In the end, however, Opec had to quit. Firstly, shale producers were becoming more efficient. Improvements to technology and sheer desperation helped to lower the cost of production. Secondly, the ongoing very forgiving interest rate environment meant that shale groups could stay alive on borrowed cash, despite the high-risk outlook.

And finally, the Opec nations were running short of cash themselves. It’s hard to keep restive populations happy when you’re having to slash public spending budgets.

As a result, in late 2016 (by which point, prices had started to find a floor in any case), Opec and Russia teamed up to agree on production cuts. This cemented the floor under the price, and helped to turn oil around again. Over the last 12 months or so, the price has risen by roughly 50%.

The question now is: what happens next? The price (as measured by Brent crude, the European benchmark) went as high as $80 a barrel recently, but it’s since slid to closer to $70. Are we heading for another crash, or is this a breather before it’s onwards and upwards?

What’s next for oil prices

There are a number of variables at play here. Supply from a few big producers is under threat. Venezuela’s supply has collapsed as the economy implodes. Iranian supply is threatened by US sanctions. Libyan supply is regularly disrupted.

Equally, Donald Trump – keenly aware of the impact of rising petrol prices on US voters’ sense of well-being, right ahead of the mid-term elections later this year – is putting pressure on Saudi Arabia to pump more oil.

And then, of course, there are fears for the global economy given that the trade picture is deteriorating by the day. A slower economy would mean lower demand for oil.

In the longer run, however, my own view is that oil is back in a bull market. The big oil groups are still wary of spending too much on exploration. They are also concerned about the potential of electric vehicles to dent demand for oil permanently.

So I suspect that the bull market won’t end until we’re back at the stage where we’re worried about running out of oil, we’ve mentally grown disillusioned with the idea of electric cars taking over any time soon, and where the oil majors are once again exploring exotic locales to see if there’s any oil in them.

In other words, until we’re over-exaggerating the upside, yet again.

How to bet on oil prices

So how do you invest in the oil sector using ETFs?

You can bet on movements in the oil price directly using a wide range of exchange-traded products, including leveraged ones and short options (for if you think I’m wrong on the bullish call). If you’re a reasonably experienced trader, then feel free to experiment with them.

However, if you are a buy and hold investor by preference, or if the words ‘backwardation’ and ‘contango’ sound more like exotic dance moves than commodities market jargon to you, then I would avoid these products.

For those who are more comfortable investing in the oil sector through companies, there are a few alternatives to choose from. There are a couple of London-listed ETFs available from iShares, for example. One is iShares Oil & Gas Exploration & Production (LSE: SPOG), which holds “a broad range of global companies involved in the exploration and production of oil and gas”. It has 80 holdings and a total expense ratio of 0.55%. The top five holdings make up about a third of the portfolio in value terms, and include North American oil groups such as EOG Resources, ConocoPhillips and Canadian Natural Resources. Roughly four-fifths of the portfolio is listed in North America.

Another is iShares S&P 500 Energy Sector (LSE: IUES). It’s a cheaper fund with a total expense ratio of 0.15%, and a more concentrated one, with just 31 holdings (all of them in the US), and more than half of the portfolio’s value accounted for by the top five holdings. These include Exxon Mobil, oil services giant Schlumberger  and Chevron.

Over in the US, there’s a wide selection. If you are particularly interested in fracking, then one to look at is the VanEck Vectors Unconventional Oil & Gas ETF (NYSE: FRAK). Bear in mind, though, that the biggest holding is EOG Resources, the same as the SPOG fund mentioned above.

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