Oil is one of the most important commodities in the world, providing energy for transportation, manufacturing, and many other sectors. However, oil is also facing significant challenges in the face of the global energy transition, which aims to reduce greenhouse gas emissions and shift to cleaner and renewable sources of energy. How will oil fare in the future, and how can investors take advantage of the opportunities and risks in the oil market? This article will explore these questions and provide some guidance on how to invest in oil.

Oil Demand and Supply

The demand and supply of oil are influenced by many factors, such as economic growth, population, technology, geopolitics, environmental policies, and consumer preferences. According to the International Energy Agency (IEA), global oil demand is expected to recover from the pandemic-induced slump in 2020 and reach a peak of about 104 million barrels per day (mb/d) in 2026, before declining gradually to 95 mb/d in 2040¹. The main drivers of oil demand growth are the emerging economies, especially China and India, where oil consumption is still rising as income and living standards improve. However, oil demand in the advanced economies is projected to decline as efficiency gains, fuel switching, and electrification reduce the need for oil.

On the supply side, the IEA estimates that global oil production capacity will increase from 102 mb/d in 2020 to 110 mb/d in 2026, mainly due to the expansion of US shale oil and the recovery of OPEC+ output¹. However, after 2026, the IEA expects that oil production capacity will decline to 103 mb/d in 2040, as conventional fields mature and investment in new projects falls short of the level needed to offset natural decline rates. The IEA warns that this could create a supply gap and a risk of price volatility in the medium to long term, unless there is a faster transition to alternative energy sources.

Oil Prices and Volatility

The price of oil is determined by the interaction of demand and supply in the global market, as well as by the expectations and sentiments of market participants. Oil prices are notoriously volatile, as they are affected by various shocks and uncertainties, such as geopolitical conflicts, natural disasters, technological breakthroughs, and policy changes. For example, in 2020, oil prices collapsed to negative territory in April, as the COVID-19 pandemic caused a historic drop in oil demand, while a price war between Saudi Arabia and Russia flooded the market with excess supply². However, oil prices rebounded strongly in the second half of the year, as the OPEC+ group agreed to cut production and the rollout of vaccines boosted the outlook for oil demand recovery.

As of April 2021, the price of Brent crude, the international benchmark, was around $65 per barrel, while the price of West Texas Intermediate (WTI), the US benchmark, was around $60 per barrel³. These prices are significantly higher than the average of $42 per barrel for Brent and $39 per barrel for WTI in 2020⁴. However, they are still lower than the average of $64 per barrel for Brent and $57 per barrel for WTI in 2019⁴. The IEA forecasts that the average price of Brent crude will be $60 per barrel in 2021 and $58 per barrel in 2022, assuming that the OPEC+ group maintains its current production policy and that the global oil demand recovers in line with the IEA's base case scenario¹.

However, the IEA also acknowledges that there are significant uncertainties and risks that could affect the oil price outlook, such as the pace and effectiveness of the vaccination campaigns, the emergence of new variants of the virus, the extent and duration of the lockdown measures, the response of the OPEC+ group to the changing market conditions, the resilience of the US shale oil industry, the impact of the energy transition policies, and the evolution of consumer behavior and preferences. Therefore, investors should be prepared for possible price fluctuations and volatility in the oil market.

How to Invest in Oil

Investors who are interested in oil have several options to gain exposure to the commodity, either directly or indirectly. Here are some of the most common ways to invest in oil:

- Oil Futures and Options: These are contracts that allow investors to buy or sell a specific amount of oil at a predetermined price and date in the future. Oil futures and options are traded on exchanges, such as the CME Globex, where investors can choose from various contracts with different delivery points, expiration dates, and quality specifications. Oil futures and options are suitable for investors who want to speculate on the direction of oil prices, hedge against price risks, or take physical delivery of oil. However, oil futures and options also involve high leverage, margin requirements, rollover costs, and liquidity risks, and they require a high level of expertise and market knowledge to trade successfully⁵.

- Oil Exchange-Traded Products (ETPs): These are funds that track the performance of oil or oil-related indexes, such as the S&P GSCI Crude Oil Index or the Bloomberg WTI Crude Oil Subindex. Oil ETPs are traded on stock exchanges, such as the NYSE Arca or the NASDAQ, where investors can buy or sell them like shares. Oil ETPs are suitable for investors who want to gain exposure to oil prices without dealing with the complexities and costs of trading oil futures and options. However, oil ETPs also involve tracking error, meaning that they may not deliver the exact return of the underlying index or oil prices, due to fees, expenses, rebalancing, contango, or backwardation⁵.

- Oil Stocks: These are shares of companies that are involved in the exploration, production, refining, transportation, or marketing of oil and oil products. Oil stocks are traded on stock exchanges, such as the NYSE or the NASDAQ, where investors can buy or sell them like any other shares. Oil stocks are suitable for investors who want to benefit from the growth and profitability of the oil industry, as well as from dividends and capital appreciation. However, oil stocks also involve company-specific risks, such as operational, financial, regulatory, or environmental risks, and they may not always move in tandem with oil prices, depending on the company's business model, strategy, and performance⁵.

- Oil Mutual Funds and Exchange-Traded Funds (ETFs): These are funds that invest in a diversified portfolio of oil stocks, oil ETPs, or oil futures and options, depending on the fund's objective and strategy. Oil mutual funds and ETFs are also traded on stock exchanges, where investors can buy or sell them like shares. Oil mutual funds and ETFs are suitable for investors who want to gain exposure to the oil sector as a whole, without having to select and manage individual securities. However, oil mutual funds and ETFs also involve fees, expenses, and management risks, and they may not always reflect the performance of the oil market, depending on the fund's composition, weighting, and rebalancing⁵.

Conclusion

Oil is a vital commodity that plays a key role in the global economy, but it is also facing significant challenges in the face of the energy transition. The future of oil will depend on the balance of demand and supply, as well as on the expectations and sentiments of market participants. Oil prices are volatile and influenced by various factors, such as economic growth, technology, geopolitics, environmental policies, and consumer preferences. Investors who are interested in oil have several options to gain exposure to the commodity, either directly or indirectly, through oil futures and options, oil ETPs, oil stocks, or oil mutual funds and ETFs. Each of these options has its own advantages and disadvantages, and investors should carefully consider their risk appetite, investment objectives, and market knowledge before investing in oil.

FAQs

- Q: What is the difference between Brent crude and WTI?
- A: Brent crude and WTI are two of the most widely used benchmarks for oil prices. Brent crude is sourced from the North Sea and represents the average price of oil from Europe, Africa, and the Middle East. WTI is sourced from Texas and represents the average price of oil from North America. Brent crude and WTI differ in quality, transportation, and market access, and they often trade at different prices, depending on the supply and demand conditions in each region.

- Q: What is contango and backwardation?
- A: Contango and backwardation are terms that describe the shape of the futures curve, which is the relationship between the spot price and the futures price of a commodity. Contango occurs when the futures price is higher than the spot price, meaning that the market expects the commodity to become more expensive in the future. Backwardation occurs when the futures price is lower than the spot price, meaning that the market expects the commodity to become cheaper in the future. Contango and backwardation affect the returns of oil ETPs, as they have to roll over their futures contracts to maintain their exposure to oil prices.