Russia’s invasion of Ukraine has sent the oil and gas markets soaring in 2022, as Western sanctions have limited the supply of oil from the world’s second largest exporter.
Prices for crude oil and natural gas have reached their highest levels since 2008, and supply is expected to remain tight because of structural production constraints.
Brent crude price
US natural gas price
Oil and gas prices plunged at the start of the Covid-19 pandemic, as government-ordered lockdowns around the world dented demand from manufacturers and businesses. Producers responded by cutting output to support the market, but demand has since rebounded.
The Organisation of Oil Exporting Countries (OPEC) has opted not to increase supply, despite calls from the US and the UK. Partially, this was due to producers in the Middle East being wary of tipping the market back into oversupply. Also, investment in maintenance dropped during the pandemic, making it difficult for some installations to meet their existing quotas.
The heightened volatility has increased interest among investors to add exposure to oil and gas to their portfolios and profit from price swings. In this article, we look at how to invest in oil and gas, the pros and cons of having exposure to the commodities, and the outlook for the market from industry analysts.
How to invest in oil and gas
There are several different ways you can invest in oil and gas depending on your approach and portfolio strategy.
Oil and gas stocks
Rather than trading on oil and gas prices directly, you can gain exposure to the market by investing in the stocks of companies involved in the oil and gas space.
You can invest in world’s biggest oil producers, like Exxon Mobil (XOM) and Chevron Corporation (CVX), and gain exposure to service providers and equipment supplies. You can buy and sell stocks in companies throughout the complete oil and gas supply chain.
You can target your holdings to certain regions or market sectors, as well as backing specific oil and gas investment companies. If you are looking to invest in oil and gas for the long term, owning stocks allows you to hold a position for years or even decades.
Oil and gas stocks can provide large capital gains from rising share prices when prices are high. The companies in the industry tend to pay higher dividends than other sectors, as they generate large amounts of cash when prices climb, making them an attractive option for income-focused investors.
Oil and gas futures
Owning oil and gas stocks gives you indirect exposure to the commodity markets, but if you want to trade directly on oil and gas prices, futures markets closely track prices without the obligation to take delivery.
Trading oil and gas futures requires different knowledge and skills to trading stocks. Futures contracts allow traders and investors to speculate on the price of a certain amount of oil or gas on the settlement date.
CME Group provides futures contracts for West Texas Intermediate (WTI) crude oil and Henry Hub natural gas in the US trade on the New York Mercantile Exchange (NYMEX). Each WTI contract represents 1,000 barrels of crude oil, while each natural gas contract represents 10,000 million British thermal units (mmBtu). You can also trade futures for 1,000 barrels of Brent crude oil on the Intercontinental Exchange (ICE).
Some futures contracts require physical delivery to the specified hub on expiry, although most contracts are cash settled. Month-ahead oil futures contracts stop trading on the third day before the 25th day of the month before the contract month.
Crude oil producers and consumers trade futures contracts to hedge their production risks and costs, while traders use them to speculate on short-term price volatility. To trade oil and gas futures as an investor, you need to use a broker that provides access to futures contracts in your account.
Exchange-traded funds (ETFs)
Using exchange traded funds (ETFs) for oil and gas investment offers the convenience of trading company stocks while providing exposure to commodity prices.
You can gain diversified exposure to a broader range of companies by investing in a sector ETF, or you can gain closer exposure to the commodity market by investing in an ETF that tracks prices.
ETFs are sold on exchanges like stocks, making it convenient for investors to open and close positions. And like stocks, you can hold ETFs for long-term oil and gas market exposure in your portfolio.
Benefits of oil and gas investments
The oil and gas market has the potential to be among the best performing sectors when prices are high, generating strong returns for investors. Below are five opportunities investors can gain from oil and gas investment.
Potential capital gains. The high volatility in oil and gas prices creates opportunities to profit from buying low and selling high. Investing in company stocks can produce capital gains from rising share prices and dividend income.
Portfolio diversification. Oil and gas prices have low correlations to stocks and bonds, so exposure to the commodity markets can help you diversify your investment portfolio and hedge against fluctuations in the financial markets.
Inflation hedge. In addition to general portfolio diversification, oil and gas investments provide a hedge against rising inflation, which reduces the value of fiat currencies.
Commodity super cycles. Commodities like oil and gas tend to trade in cycles and could be at the start of a new commodity super cycle because of structural changes, such as supply chain dynamics and population growth. This creates opportunities for investors to profit.
Energy demand. Oil and gas are at the centre of modern economies and will remain in demand in the years to come. This will support the stocks of companies pursuing oil and gas investment opportunities in the medium term.
Risks of investing in oil and gas
While there are opportunities you can gain from oil and gas investments, as with any market sector there are risks that future returns may not match expectations – particularly given the high volatility in oil and gas prices. Below are five risks associated with oil and gas investments.
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Geopolitical events. As has been evident over the past few years, oil and gas markets have been affected by geopolitical events like the Russia-Ukraine war.
Supply demand and shocks. Unexpected events such as the Covid-19 pandemic can disrupt oil and gas demand and price wars among suppliers – as seen between Saudi Arabia and Russia in 2020 – can affect output.
Clean energy. Over the long term, the shift to green energy and electric vehicles could reduce the global demand for oil and gas products.
Regulation. Government permitting processes, environmental restrictions and other regulations can change over time, increasing the risk that a company may not be able to deliver on projects, or costs may increase.
Declining resources. Oil and gas reserves are depleting as the easiest oil fields have been exploited. Companies must invest more resources in the future to access harder to reach reserves, which would affect their profit margins.
Oil and gas industry outlook
by TD Securities
In the near term, geopolitical tensions and demand trends are expected to support oil and gas prices.
“With prices having already surged to their highest levels in a decade, fears of demand destruction are now also creeping into traders’ psyche. Energy producers already face sky-high incentives to turn on the taps,” noted analysts at Canada’s TD Securities.
“This begs the question: is the supercycle in oil markets already turning over? We think not. Even in a recession, oil prices could remain elevated, since little progress has been made towards solving structural supply challenges.
“Further, recessions don’t have a great track record of destroying demand. With little evidence of demand destruction on the horizon, energy security may even be stressed by a slow demand growth profile.”
Some analysts are also bullish on the longer-term outlook.
“While the recent sell-off in equities (-10% over the last week) reflects a growing concern of a global recession, the upstream industry is in fantastic financial shape as companies have right sized operating costs over the past few years, lowered base decline rates, and put balance sheets into pristine shape,” said analysts at TPH Research.
“Additionally, we remain constructive on the macro backdrop for crude oil over the next several years as spare capacity globally continues to dwindle dropping below 2mmbopd by 2025 and potentially setting up for a scenario where crude could trade closer to $100/bbl over that time frame.”
Analysts at Dutch bank ING suggested there was potential for upside in oil prices.
“We do not think OPEC will tap more aggressively into its limited spare capacity, which suggests that the oil market will be in deficit over 2H22, which should see prices edge higher (Brent at $125/bbl over 4Q22),” they said in a note.
“Demand destruction has helped to ease some of the tightness in the market although clearly not enough to fully offset the Russian supply losses we expect as we move through the year.”
ING also highlighted that there are both upside and downside risks, including further trade restrictions on Russian oil, the end of war in Ukraine and new waves of Covid-19 lockdowns in China.
“There are clear risks to our view. To the upside, the biggest risk would be if we were to see secondary sanctions placed on Russian oil. This would make it much more difficult for Russia to sell into markets like India and China, which would mean that the global market would be even tighter than we expect,” analysts said.
“On the downside, the potential for further Covid-related lockdowns in China over the course of the year could weigh on oil demand. However, the bigger downside risk is if we see a de-escalation in the war or even an end to it (hopefully). This would likely see a significant amount of risk premium given back.”
Note that analysts’ predictions can be wrong. Forecasts shouldn’t be used as substitutes for your own research. Always conduct your own diligence and remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals.
Keep in mind that past performance doesn’t guarantee future returns. And never invest or trade money you cannot afford to lose.