Following the recent oil price crash, the price of oil looks cheap. As such, many investors have considered buying oil ETFs as a way to bet on its recovery.
However, while these products might look like an excellent way to bet on the oil price, they have some significant drawbacks.
Oil ETFs: complex products
The most significant difference between oil ETFs and the oil price is the fact that these products only try to track the price of oil. That does not guarantee that they will track the price of oil.
In fact, due to the way these products are constructed, their performance tends to vary widely.
It all comes down to the way the oil market works.
Oil is traded on short-term contracts. Oil ETFs buy these contracts to gain exposure to the oil price. But they then have to sell and buy new contracts at the beginning of every month to maintain their exposure to the oil price. This trading can increase costs, especially if the contract they are buying is trading at a higher price to the one they are selling.
This happens regularly in the oil market, especially during times of market stress.
As a result, oil ETFs can be quite good at tracking the oil price on a day-to-day basis. But over the space of a week or month, these products tend to lose money for investors.
Another reason why I wouldn’t buy oil ETFs is the fact that no one knows what the future holds for the price of oil.
Trying to bet on market movements over the next few weeks or months is always going to be difficult. It’s even more so in the current economic environment.
As we’ve seen over the past few years, there’s no guarantee the price of oil will ever return to historic highs. Anyone who has tried to bet on that happening has lost money.
So, unless you are looking for a good way to waste your hard-earned money, it might be better to stay away from oil ETFs altogether.
Instead of betting on the oil price, it could be more sensible to buy individual oil stocks.
Some companies won’t survive the current climate. However, others might emerge stronger.
Here at The Motley Fool, we are long-term investors. That means we like to buy high-quality companies with strong balance sheets and durable competitive advantages. There are a handful of such companies in the oil sector. Royal Dutch Shell and BP are great examples. Both of these companies have large refining and marketing operations, as well as oil production, which provide a steady stream of cash. This will help them survive the volatile oil environment as others struggle.
If you want to bet on a rising oil price, investing in these companies could be the best way of doing so. They might not generate the same sort of high short-term returns oil ETFs offer, but over the long run, these businesses should generate a positive capital and income performance.
Oil ETFs are unlikely to provide the same sort of positive return.
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Rupert Hargreaves owns shares Royal Dutch Shell. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.