I think every portfolio should contain some exposure to oil. Oil is one of the most essential commodities on the market today, and by owning oil you get a hedge against inflation, exposure to economic growth, and exposure to economic activity more generally. Unless there is a radical new discovery that makes oil and fossil fuels obsolete, oil will be in strong demand, and if you pick the right assets in the oil sector, you can do extremely well.
But how should you buy oil? There are hundreds, if not thousands of stocks out there of companies that in some way profit from the exploration for, the production of, and the shipment of oil? The difference between picking the right one and the wrong one could mean the difference between making fortunes and losing your investment. In what follows I have provided readers with a few ideas.
1. Buy an oil futures contract or ETF
The most straightforward way to invest in oil is to simply buy oil. Since most retail investors don’t play the futures market, the best way is through an ETF such as the United States Oil Fund LP (NYSEARCA:USO). This fund buys oil futures contracts, and yet it trades on the NYSEARCA like an ETF. The great thing about this fund is that if you buy it you don’t have to worry about company risk such as rising production costs, politics, acts of God such as the BP (NYSE:BP) Gulf Oil Spill, or incompetent executives. The downside is that a good oil company makes money even in a falling oil price environment, whereas the USO trades with the price of oil. Another problem is that you have to deal with the fact that the fund has to sell old futures contracts and buy new ones every month. This adds costs and detracts from the fund’s value over long periods of time. So this is perhaps best used as a trading vehicle, but I wouldn’t hold it long-term.
2. Buy an integrated oil company
For those investors looking for stability, strong cash-flow streams, and dividends, consider buying an integrated oil company such as Exxon Mobil (NYSE:XOM). These companies are boring but they create long-term value by integrating the various aspects of oil production and exploration. These companies also own their own refining divisions. The downside is that these companies are not highly leveraged to the oil price. They also have very slow growth. Their profits will generally rise with the price of oil, but it is rare to see these companies post double digit earnings growth, and this is going to hold their price to earnings multiples back. But if you’re looking for a company that can generate high single digit to low double digit returns over the very long-term, and if you like stable and rising dividends, these are stocks worth buying on weakness.
3. Buy an oil service company
Oil service companies provide equipment and technology to oil producers and explorers. This can include drilling supplies, oil rigs, or even geological information. The great thing about these companies is that if they are well run they can generate very stable income that doesn’t fall if the price of oil declines. Furthermore, they are, in essence, technology companies. So if you find a good one you can get exposure to the tech sector without having to worry about things such as advertising or the price per click. You also don’t have to pay very high prices for oil service companies when compared with, say, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) or Facebook (NASDAQ:FB).
If you’re looking at oil service stocks you can get very particular by looking at tiny companies that focus on one specific thing such as a geographical region or a new technology. If you do the work you can find a gem among the dozens of these companies. However, if you are simply looking for exposure to the sector there are some excellent large cap companies that will generate stable returns and consistent long-term growth such as Schlumberger (NYSE:SLB).
4. Buy an exploration and production company
If you are looking for leverage to the oil price and have the time to do the research, this is probably the best way to make a lot of money in the oil space. There are several companies that are making new discoveries and growing production at a rapid pace, and this can leverage your oil exposure if you pick the right companies. Since hydraulic fracking has become popular you can find many companies with new, rapidly growing discoveries in Texas, North Dakota, Montana, and New England. However, keep in mind that there are a lot of duds out there, and also keep in mind that there are a lot of very smart people looking for success stories in this industry, and so you have to make sure that you don’t overpay for these stocks. But if you look under the radar you can find undiscovered gems that can make you a lot of money.
Disclosure: Ben Kramer-Miller is long Exxon Mobil.