Introduction
Crude oil is one of the world’s most important commodities. It is refined into fuels such as gasoline, diesel, and jet fuel and is also used as a feedstock for petrochemicals and many industrial products.
Oil prices can move sharply because supply and demand must continually adjust to economic activity, production decisions, inventories, transportation constraints, and geopolitical events. That volatility can attract investors, but it also creates substantial risk.
Individual investors generally do not buy physical barrels of crude oil. Instead, oil exposure is usually obtained through futures, exchange-traded products, or shares of companies in the energy industry.
How the oil market works
Crude oil is produced in many regions and comes in different grades. Two widely followed price benchmarks are West Texas Intermediate, commonly called WTI, and Brent crude. Their prices can differ because of quality, geography, transportation, and regional supply-and-demand conditions.
Producers sell crude oil to refiners, which convert it into usable products. Traders and commercial businesses also use futures and other contracts to manage price risk or gain market exposure.
Because oil is a physical commodity, storage and transportation matter. A barrel available in one location is not automatically equivalent to a barrel available somewhere else once transportation costs and infrastructure constraints are considered.
What drives oil prices?
Oil prices are determined by global supply and demand, but both sides of that balance can change quickly.
Global demand
Transportation, industry, economic growth, efficiency, and changes in energy use all affect demand for petroleum products. Economic slowdowns can reduce demand, while stronger activity can increase it.
Production
Output from major producing countries, private energy companies, and coordinated producer groups can materially affect global supply.
Inventories and spare capacity
Stored oil can help absorb temporary imbalances. Markets can become more sensitive to disruptions when inventories are low or producers have limited spare capacity.
Geopolitics and infrastructure
Wars, sanctions, political instability, pipeline disruptions, shipping constraints, and refinery outages can affect the availability and movement of oil.
OPEC and oil supply
The Organization of the Petroleum Exporting Countries, together with cooperating producers often referred to as OPEC+, can influence the oil market through coordinated production targets. Changes in output policy can affect expectations for future global supply.
These producers do not control the oil price completely. Production outside the group, compliance with output targets, global demand, inventories, and market expectations all matter.
Oil supply can also respond to prices over time. Higher prices may encourage additional investment and production, while sustained low prices can discourage drilling and make some projects uneconomic.
Ways to invest in oil
Direct ownership of crude oil is impractical for most individual investors because oil must be transported and stored under appropriate conditions. Financial markets provide several alternatives. For a broader comparison of futures, exchange-traded products, physical commodities, and commodity-related stocks, see how to invest in commodities.
Oil futures
Futures contracts are central to oil trading. A futures contract specifies the purchase or sale of a particular crude oil grade at a future date under standardized terms.
Futures can provide direct exposure to oil-price movements, but they involve leverage, margin requirements, and expiration dates. Investors who want to maintain exposure must generally close or replace contracts as they approach expiration.
Oil exchange-traded products
Some exchange-traded products seek to provide exposure to oil through futures contracts. They can make oil exposure accessible through a brokerage account, but their returns may differ significantly from changes in the spot price of crude oil.
This difference is largely related to the structure of the futures market and the cost or benefit of replacing expiring contracts. Fund expenses also reduce returns over time.
Energy stocks
Investors can also buy shares of companies involved in oil exploration, production, refining, transportation, or oilfield services. These are stocks rather than direct commodity investments.
Oil prices can strongly influence energy-company earnings, but business results also depend on production costs, debt, capital spending, management, refining margins, reserves, contracts, and other company-specific factors.
Why futures-based oil funds can differ from oil prices
A common misunderstanding is that an oil fund must produce the same return as the quoted spot price of crude oil. Futures-based products can behave differently because they hold contracts with expiration dates rather than physical oil priced for immediate delivery.
When later-dated futures contracts are more expensive than contracts nearing expiration, replacing an expiring contract can create a drag on returns. This market condition is commonly called contango.
When later-dated contracts are cheaper than near-term contracts, the replacement process can be more favorable. This condition is known as backwardation.
As a result, an investor can correctly anticipate the general direction of oil prices and still receive a different return from a futures-based product than expected.
Oil investing versus energy stocks
| Characteristic | Direct or futures-based oil exposure | Energy stocks |
|---|---|---|
| Primary exposure | Crude oil prices and futures-market structure | Business profits and stock-market valuation |
| Cash flow | The commodity itself does not generate earnings | Companies may generate earnings and pay dividends |
| Major additional risks | Futures roll effects, leverage, fund structure | Management, debt, operating costs, reserves, capital spending |
| Relationship with oil prices | Can be relatively direct, but not necessarily identical to spot oil | Indirect and dependent on company economics |
Energy stocks may benefit from higher oil prices, but they should not be treated as a perfect substitute for crude oil itself.
Oil, inflation, and the economy
Energy costs affect transportation, manufacturing, and household spending, so large changes in oil prices can influence inflation and economic conditions.
Higher oil prices can raise costs for consumers and businesses, particularly when the increase is rapid. Lower prices can reduce some of those costs, although they may also hurt energy producers and regions that depend heavily on oil production.
The relationship works in both directions. Economic growth can increase oil demand and support prices, while recessions or expectations of weaker activity can reduce demand and pressure prices.
Risks of oil investing
Oil is a volatile commodity. Geopolitical developments, economic data, production changes, inventory reports, weather, and unexpected disruptions can produce large price movements over short periods.
Futures add leverage and contract-specific risks. Futures-based funds can experience roll costs and tracking differences. Energy stocks introduce business risks and can decline because of company or stock-market factors even if crude oil prices are relatively stable.
Longer-term changes in energy efficiency, regulation, technology, and the global energy mix can also affect oil demand and the economics of oil-producing companies. For more detail on leverage, roll risk, product structure, and other concerns, see the risks of commodity investing.
What investors should understand before gaining oil exposure
The first question is what type of exposure an investment actually provides. A futures-based fund, an integrated energy company, and an oilfield-services stock can all be described as oil-related investments, yet their returns may differ substantially.
Investors should also understand leverage, expenses, futures roll mechanics, company balance sheets, and concentration risk where relevant. Oil exposure can add a different set of return drivers to a portfolio, but volatility can be considerable.
Oil is one part of the broader commodity market. Its dependence on physical production, storage, transportation, and global economic activity makes it a useful example of how commodity markets differ from stocks and bonds.
Key takeaways
- Crude oil is a major global commodity used primarily for fuels and petrochemical products.
- Oil prices are driven by global supply and demand, inventories, production decisions, economic activity, infrastructure, and geopolitics.
- Most individual investors gain oil exposure through futures-based products or energy stocks rather than physical crude oil.
- Futures-based oil investments can perform differently from spot oil because contracts expire and must be replaced.
- Energy stocks are businesses and add company-specific risks that direct commodity exposure does not have.
- Oil can be highly volatile, and the structure of the chosen investment is an important part of its risk.