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Should You Add Oil to Your Portfolio?

Crude oil made headlines in June, 2008, when the average price of a single barrel of WTI (West Texas Intermediate) crude reached an inflation-adjusted $171.35 for the first time ever. The spike came as the result of a series of supply shocks that disrupted the typical market as well as widespread investor speculation heading into the Financial Crisis that fall. Within months, crude oil prices plunged back to normal levels.

Oil ETF DBO backtested from inception through December 31st, 2010.

Oil ETF, DBO's performance through the Global Finanical Crisis January 5th, 2007 through December 31st, 2010.

Fast forward to 2020, when a glut of surplus oil on the market during the early months of COVID-19 led to ultra-low prices for the commodity, as low as $11.18 per barrel. As the world returned to some sense of normal in the wake of the pandemic and more and more people hit the road for work and travel, the price of oil began to creep back up again.

Then, in 2022, gas prices across the U.S. jumped sharply once again on the back of rising inflation and supply disruptions due to Russia’s invasion of Ukraine, which interrupted one of the largest oil supply lines in Europe.

And the cycle began again.

For investors, volatility like this can be greatly beneficial, offering not only attractive trade entry points when prices fall to lows but also the potential for rich exit returns when commodity prices swing to highs. With the oil market in particular, which is impacted by a wide range of different forces — from geopolitical concerns, to demand spikes, to interest rates and broader economic issues — this volatility allows investors to profit from the ups and downs of one of the world’s most popular commodities. It is no wonder, then, that Warren Buffett looks at commodities to hedge against inflation and continues to remain bullish on this theme.

But is it a good investment that belongs in your portfolio? As with any asset class, it depends on your investment strategy and overall goals. However, as part of a diversified portfolio along with other commodities, stocks and bonds... it might deserve a look.

Why Oil Is a Good Investment

Crude oil is classified as a commodity, an asset class that includes a wide range of physical goods such as natural gas, precious metals, agriculture commodities, and more. As such, it enjoys the various benefits that set all commodities apart from common investment options — namely, as a hedge against inflation, an option for portfolio diversification, and an asset that is largely isolated from the gyrations of the broader stock market.

That’s because when you buy a commodity, you are not buying a share of a company, but rather a securitized version of an underlying raw material. If the value of that commodity rises, you benefit. Although commodity prices can rise and fall based on a broad array of factors, at its core the price of a commodity like crude oil is the same for every investor at any given moment.

Learn more about commodities as an asset class.

But, beyond the advantages of commodities as an asset class, oil investing offers a few other benefits.

Price appreciation: As demand and supply forces impact the price of oil, investors can benefit from this appreciation by buying low and selling high. Although they can be volatile, oil prices tend to rise over time, as global demand has remained strong.

Dividends: Many securitized oil investments, such as exchange-traded funds and mutual funds, allow investors to combine their commodity holdings of crude oil with stakes of oil companies, oil producers, and other industry players. Typically, these types of oil stocks pay a dividend, allowing investors to tap into a regular income stream to grow their portfolio on top of the price appreciation of the underlying commodities. A steady dividend yield and consistent cash flow can often be highly attractive to some investors, especially given lofty valuations in other sectors.

Non-correlation: Commodities like oil offer investors portfolio diversification that is largely isolated from the broader stock market, making for a good hedge against stock prices when things get volatile during unpredictable economic times.

Risks of Investing in Oil

Of course, as with any investment, oil investing comes with its own share of risk, and investors should consult their financial advisor if necessary. Given that its price is based on a broad set of real-world factors, oil rises and falls for reasons that are different from those impacting stocks and bonds. Sometimes that can be a good thing, isolating the asset class from the larger market, but in other instances, it can open up commodities like oil to unique risk factors.

Macroeconomic risk: As we saw at the start of the COVID-19 pandemic in 2020, broad economic forces can have a significant impact on the price of oil. As millions of people stayed home to isolate in the face of the virus, oil demand plunged, and prices fell sharply. It took a few months for per barrel prices of crude oil to start to recover once the world returned to normal. Oil might be distinct from the stock market, but not from the economy at large.

Geopolitical risk: The Russian conflict in Ukraine disrupted Europe’s access to Russian oil; unfortunately, Russia was a primary supplier to the continent. Oil prices rose in the wake of the conflict, as they have in similar cases in the past. Conflicts in the Middle East, where Saudi Arabia and OPEC largely control the supply of oil, impact global prices. In general, geopolitical tensions lead to oil production and supplies being squeezed. Investors have no control over these geopolitical forces, but they represent a significant risk factor.

Demand changes: Climate change and ESG investing trends have many pushing for change in the oil markets, namely a reduction in the use of fossil fuels and a shift to more renewable energy sources. While the shift to electric vehicles and renewable energy represents a longer-term trend, pressure from ESG investors and governments creates a potential risk factor in the short term as well.

Volatility: Although volatile asset prices can be good for investors looking to capitalize on short-term trends, they can also be risky for those investors who are looking more for stability from their holdings. The reality is that the oil and gas industry is volatile, and investors who aren’t prepared for significant price moves can be caught off guard when asset prices fall.

How to Invest in Oil

There are several ways to invest in oil, although buying and storing physical barrels is less common than with other commodities like gold or silver. Fortunately, the market offers a number of different mutual funds, ETFs, futures contracts, and individual energy stocks that are related to the price of oil. Each comes with its own set of advantages and disadvantages depending on your investment goals and portfolio needs.

For instance, two common oil ETFs — the Invesco DB Oil Fund (DBO) and the Vanguard Energy ETF (VDE) — address the asset class in two different ways. DBO focuses on futures contracts on oil, making it a cost-effective and convenient way to invest in commodity futures that track the price of oil. VDE, on the other hand, takes a broader view and tracks the entire energy sector, including the stocks of oil and gas companies, explorers, oilfield services, and energy producers of natural gas and coal.

Both have their place in a properly diversified portfolio, though strict oil investors would likely look to DBO as a more focused pure play on oil prices. Whatever your goal, Composer makes it easy to compare ETFs like DBO and VDE using correlation data to determine how closely aligned the two funds actually are. In this case, VDE and DBO are 0.65 correlated from 2007 through October 18th, 2022, indicating a partial but not complete overlap in exposure.

With Composer, investors can also simulate the impact that adding oil to their portfolio might have, using backtest data to see what might have happened. This can be a useful way to test out potential portfolio diversification, showing returns, drawdowns, and overall volatility over a period of time in the past. With this information, you can make the investment decision that is best for you and your portfolio goals, whether they involve oil or not.

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