Bargain Hunters Looking at Oil (part 2 of 2)

By Brian Dolan, Head Market Strategist

 

Tactical Considerations for Investing in Energy

In Part 1, I offered my view on the outlook for oil prices in the months ahead. The main takeaway is that I still see potential for further near-term weakness in crude oil prices until the early summer months. For investors looking to gain exposure to energy-related investments, that suggests there may still be opportunities to invest in energy at even lower prices in coming months.

One tactical approach in such a scenario is called “averaging-in.” The idea is to stagger investments as a portion of a total desired investment amount at various lower price levels. For example, an investor may want to invest a total of $1000 in energy-related investments. Using WTI as a proxy, let’s say WTI is currently at $55 per barrel. As an example, an investor could seek to buy 25% of their energy allocation at current prices, 25% at $45, 25% at $35, and the final 25% at $30 (or any other price levels they choose).

If the market cooperates (and there is no guarantee it will), the investor would have their desired energy-sector investment at an average cost of $41.25, or 25% cheaper than current price levels, in this example. If prices were to move directly higher, the investor would still have ¼ of the desired investment from current prices, and could then add to it as they see fit.

Dollar-cost averaging is another way to act on your views of the direction of oil prices and the energy sector, potentially lowering the overall cost of your energy-related investment.

How to Invest in the Energy Sector

The most direct way to invest for a view that favors higher crude oil prices is to buy crude oil itself. Buying crude oil directly would typically be done through the futures markets, but that can be an expensive and complicated process.  An easier way to invest in crude is to buy an ETF that tracks an index of benchmark crude oil prices, such as USO (United States Oil Fund), or OIL (iPath S&P GSCI Crude Oil Total Return Fund).

Beyond crude, investors may be looking to take advantage of sharp declines in oil and energy related companies as individual stocks. Here, it’s important to differentiate between the types of companies and where they fit in the oil pipeline (no pun intended).

Beyond Crude Oil

Most companies fall into two main categories: upstream and downstream energy companies.

  • Upstream energy companies are the ones at the beginning of the crude production chain—exploration, drilling, shipping, oilfield services, and the like. Generally speaking, the upstream companies’ prospects move in relation to the price of oil: the more expensive oil is, the better they tend to perform; the cheaper oil gets, the worse their prospects.
  • Downstream energy companies are the ones who get the crude to end users—pipelines, storage, utilities, refining and retail distribution. Downstream energy companies tend to move in the opposite direction of oil prices overall. Higher energy prices will tend to squeeze their margins, while lower oil prices may give them more pricing power.

Some of the world’s leading energy companies, the really big ones such as Exxon (XOM), Sinopec (SNP), and BP (BP), will span the entire supply chain, from exploration to production to refining, and down to retail distribution. These vertically integrated behemoths will mostly track the price of oil, but with greater variability.

Make sure you understand where a company fits into the energy sector and how the price of their stock may be affected by changes in the price of oil before investing.

Investors have multiple options to express their view on the price of crude oil and the overall energy sector, from crude oil ETFs to individual stocks of major energy companies. There’s even energy sector ETFs, such as the iShares US Energy ETF, which aims to track the Dow Jones US Energy Sector Index.

In light of the supply/demand picture, investors may be able to build exposure at lower prices in coming months. Depending on an investor’s market view and their level of patience, they may have time on their side to construct a more dynamic investing strategy and possibly avoid catching the proverbial falling knife too soon.