February 2007 Update
Oil Market Basics
The oil and natural gas markets are always in the news lately. In this article let me lay out some of the basics so you can make more informed decisions when investing in the energy markets. Like gold the oil and gas markets respond to the world political situation. More so for crude oil because most natural gas is produced locally. Very little natural gas is imported into the U.S. While this can’t really be verified exactly I have heard estimates that $15 to $20 is the current “terror premium” on each barrel of oil. The current price of crude is $59.62 (2-8-2007) and without the threat of terrorism market forces would dictate a price of $35 to $40 a barrel. It is also possible that the extra $15 to $20 goes to fund the terrorism, but that subject is beyond the scope of this article.
Investing directly in oil or natural gas is not recommended for the beginning investor. These commodities are traded in the futures market and they require more than the average brokerage account. However there are hundreds of ways to participate in the energy markets without owning actual oil or gas. The most obvious is to buy stocks in major oil companies. Like the Dow Jones Industrial Average (^DJI) is the barometer for the large companies in the U.S. the Amex Oil Index (^XOI) is the barometer for the major oil stocks. By getting a Yahoo quote on ^XOI and clicking on Components in the left hand column of the page you can see what companies are included. The XOI is important because it is the index the big boys watch.
To view the actual price of crude oil or any other commodity click on the Gold Futures button in the red box on the left column. Then in that pages left column click on the Oil/Energy link. By clicking on Crude Oil NYMEX you will then see the prices for the different futures contracts. Viewing this page for beginning investors is helpful because you can see where the price of oil is heading. The current or “front month” in the oil market is MAR 07. By looking farther into the future you can see that the price of oil is increasing. For the new investor it would be unwise to buy oil company stocks if the price were decreasing.
For beginning investors mutual funds are usually what comes to mind first. There are many funds that concentrate on the energy markets. However with mutual funds there are all sorts of rules, such as you must pay the closing price of the day to buy and many times there are minimum investment requirements. Let me offer you a very credible alternative called exchange traded funds (ETF's) The most widely traded ETF covering the energy market is the Energy Select SPDR (pronounced spider) with ticker symbol XLE. The energy spider is currently hovering around its 50 day moving average and the bet is that current uptrend will continue. Long term investors should buy on dips. Short term investors should watch the weather and the world political situation. Both of these can cause short term price swings that can be very profitable. More sophisicated investors can short sell XLE and make money if its price drops. No short selling is another mutual fund rule.
XLE is by far the largest energy ETF trading 23 million shares per day and having a asset value of over $4 billion. The other large energy ETF's are tickers OIH, IGE, IYE, USO and IXC in case you are interested in shopping around.
To view a complete list of the ETF's available go to the Yahoo Finance ETF Center
Another way to participate in the energy markets is to purchase what are called the oil service stocks. These are companies that deliver parts and supplies to oil drillers or manufacture off shore drilling rigs for example. The barometer for this market is the OSX. Once again get a Yahoo quote on OSX and check out the Components. The oil service stocks are generally more immune from the shifting sands of world politics. However Halliburton (HAL) is the largest oil service stock and it is almost the definition of political turmoil. Therefore I believe that investing in HAL requires extra research because of the potential lawsuits from waste and fraud concerning the Iraq war.
An even more indirect play in energy market are the consumers of oil. In general if the price of crude rises the price of airline stocks decline. The same is true for trucking and railroad stocks. Sometimes it is a good idea to buy energy consumer stocks as the price of oil is falling. Besides labor costs the price of fuel is the biggest expense to the airlines. However the new investor should be wary of the airline stocks for other reasons. It is interesting that if you added up all of the profits and losses in the airlines from the Wright brothers until the present it would result in an overall loss. The reason for this is because of the intense competition airlines have to price tickets below what they actually cost. Kind of like capitalism gone crazy.
As mentioned in previous updates the astounding growth in China and India provides a floor to how low the price of oil can go. They are providing a growing demand for energy and should keep the big oil producers running at capacity for years to come. In an accompanying article by Charles Delvalle the case for oil and other commodities stocks not being in a bubble like the tech stocks of the late 1990’s is made quite clearly.
Therefore if you are a long term investor it would be a good strategy to increase your energy holding when prices drop for short term reasons. Then if the price of oil spikes dramatically because of world political unrest you are in a good position to sell into that rally for considerable profits. It takes a watchful eye to be successful in energy investing because of the political connection energy has. It also makes it more interesting.
Ken Mueller
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