In the last article for your investment training we talked about the central banks, how they work and the influence they have on financial markets. Within the theme of these articles we try to talk about topics to enrich your investment training in different areas. As we have seen throughout this year, 2022, one of the industries that has benefited the most (if not one of the few) has been the oil. And since we do not want you to invest in this sector without prior knowledge, in today's article for your investment training we are going to do a detailed analysis of the oil industry; from its origin, how to invest in it, its main virtues and disadvantages and much more...
What is oil?路♀️
Let's start this investment training on the oil industry by defining what oil is. As we well know, oil is one of the most used raw materials globally. Its use extends to multiple industries and sectors, since when it is refined it can be used for multiple uses. Of course, before being refined, the oil is called “crude oil”, given that it is the state in which it is extracted from the Earth's crust. Next we are going to delve into the origin of oil and how it was discovered. For many it is considered "black gold."
What is the origin of oil?
The origin of oil dates back millions of years. During this long period of time, there has been a process of decomposition of organic remains (both animals and plants) that little by little gathered in the deep sea and on land. Little by little these organic remains were buried beneath thousands of layers of sediment.
With the achievement of this process, more layers were formed over time, and the pressure of these thousands of layers caused a decomposition where oxygen did not give way. This process caused the thousands of layers of organic remains that accumulated over time in these conditions to end up creating an oily liquid compound, with more density than water and black in color. Natural gas was also formed with this same process. It is considered a fossil and non-renewable raw material.
Where can oil be extracted?️
As we have just explained in the previous paragraph, oil was formed by a process of decomposition of organic remains of animals and plants accumulated, among others, in the deep sea. So, the places where oil deposits are usually found to be extracted are usually found in the depths of the sea, in coastal areas and at the mouths of rivers, lakes or others. Among many other factors that we will see later in this investment training, the extraction of oil under these conditions is quite questioned due to the environmental catastrophes that they can cause (and have already caused on multiple occasions).
Map of global oil reserves. Source: EIA/ARI.
Which regions have the most oil reserves?
To a large extent, there are certain regions of the world where climatic and environmental conditions have favored the process of oil formation, such as Venezuela, Canada, Russia, Brazil, the United States and different countries in the Persian Gulf, such as Iran, Saudi Arabia, Kuwait and Qatar.
Of course, we have to differentiate between the reserves available to extract from their deposits and their production, given that there are regions that have large reserves in their deposits without being extracted (produced) in their entirety. As we can see in the two graphs that we have cited in this section, we see that the difference between the countries with the largest reserves and the largest producers differ, where those with the most reserves are not, in turn, those that produce the most of the same.
How is oil extracted?
Oil extraction (as we have previously commented in this investment training) is somewhat controversial due to the environmental consequences that accidents can cause during its extraction or transportation. As we have mentioned, oil is mostly found in the deep sea, which means that before extracting it, a topographic study must be carried out to analyze the surface that is intended to be exploited, in order to do so safely. Oil is usually found at about 5.000 meters deep.
This involves drilling into the ground and installing special pipes and storage systems. At the time the oil has been extracted, depending on the degree of refining applied, crude oil derivatives can be obtained, such as methane, butane, kerosene, gasoline, tar and other compounds.
When was oil discovered?
Oil as we conceive it today was not discovered until the arrival of the 1859th century, when in XNUMX a man named Edwin Drake managed, after months of effort and research, to suddenly emerge from the Earth's crust in the Oil Creek Valley. (Pennsylvania, USA) for the Seneca Oil company. This is the first oil well of the modern era, which in turn fueled the "oil rush."
Previously, in ancient times, historical records of its use have also been found, such as the Mesopotamian peoples trading in asphalt, gasoline and bitumen. Records of oil wells have also been found in Iran dating back to 500 BC and in China they extracted it with bamboo canes and bronze tubes for domestic and lighting uses.
How does the oil industry work?⚙️
The oil industry goes through different processes, such as extraction, refining and trading. Let's dive in depth to determine each of the parts of the oil industry:
1. Upstream.️
In this part they are in charge of the exploitation and production of oil. The companies in charge are dedicated to locating oil reserves and extracting them. These companies are also in charge of the construction and maintenance of the oil wells as well as the accommodation and care of the workers.
2. Midstream.️
This part refers to the oil industry companies in charge of transporting oil from oil wells to refineries. Oil transportation can be carried out in different ways depending on its location and the company in charge of it. As we already know, oil transportation can be carried out by railways, large ships, trucks or pipelines.
3. Downstream.⛽
This part includes the oil refining processes, that is, the sites to which it is sent after being extracted. This process is carried out by companies that, apart from carrying out the task of refining, also produce oil derivatives to finally market them on a large scale.
How is the price of oil defined? ⚖️
Mainly the price of oil is based on a principle that we have already discussed in other investment training articles; by supply and demand. Of course, as we already mentioned in another article that dealt with the raw materials market in a general framework, the price of oil can also be manipulated by its producers, as we have already experienced this year with the war in Ukraine. There is a specific organization that has a lot of influence on the price of oil:
OPEC (Organization of Petroleum Exporting Countries).
This organization, founded in 1962 in Geneva (with current headquarters in Vienna, Austria) is an alliance of 13 countries that regulate the production and export of oil (in barrels of about 160 liters) from the different regions that make up this alliance. This organization arose from the discontent of the countries that are dedicated to the exploitation and production of oil against the large multinationals that took advantage of this valuable resource. It currently consists of Angola, Algeria, Saudi Arabia, the Republic of the Congo, the United Arab Emirates, Gabon, Equatorial Guinea, Iran, Iraq, Kuwait, Libya, Nigeria and Venezuela.
During their history they have seen changes in their members, such as the abandonment of countries such as Qatar, Ecuador or Indonesia, or the incorporation of 11 other allies, including Russia. With the entry of these 11 allies, OPEC+ is understood. This organization has a lot of influence on the price of oil, given that they have 81% of the world's oil reserves, 43% of world production and 34,9% of exports.
What historical events have affected the price of oil?
Previously, geopolitical conflicts have ended up drastically altering the price of oil, such as in 1973 when the US was plunged into the oil crisis, when the entire country ran out of oil supplies, taking oil prices to exorbitant levels. at that time. This event also led the global economy into a severe recession that lasted more than 10 years and led to the Persian Gulf War years later.
We could also see how the price of oil futures contracts sank to negative levels during the time of Covid19 lockdowns, where there was little or no demand for oil. This event caused oil futures (CL1!) to reach a historic low of -40,32 dollars.
How can we invest in the oil industry?路♂️
Let's see below the different ways we have to invest in the oil industry:
Storage of physical barrels of oil.️
The first option we have to invest in oil is to acquire physical barrels, that is, storing said barrels. Of course, it is not the most convenient for investors given that it has certain obstacles such as storage and its correct treatment due to its toxicity levels and other factors.
Oil company shares.
One of the best options to invest in oil is by investing in shares of companies that are dedicated to the exploitation, production, refining and transportation of oil. These companies tend to appreciate strongly when oil prices rise, although they are also harmed when prices fall. In turn, the performance of each company may vary, given that the oil price factor is the main catalyst for the movements of these companies, although the correct management of the companies and the income/profits they obtain also largely depend. . Some of the well-known oil companies in the industry are Occidental Petroleum (OXY), Exxon Mobil (XOM), BP plc. (BP), Chevron (CVX) or Repsol (REP).
Oil futures.
Oil futures are futures contracts in which buyers and sellers of oil coordinate and agree to deliver specific quantities of physical crude oil at a certain date in the future, hence the name. Crude oil is traded on the ICE and the NYMEX, with delivery dates for the twelve months of the year. Each future contract is made up of 1.000 barrels of crude oil and its tick or minimum price variation is 0,01 dollar per barrel, that is, 10 dollars per contract. Within oil futures we can differentiate two different markets: -The West Texas Intermediate (WTI) that is extracted in Texas and Oklahoma. -Brent crude oil (BRENT) that is extracted in the North Sea. This is sweeter and lighter, which is why it is considered a higher quality oil.
Oil CFDs.
CFDs (Contracts for Difference) are similar to the futures contracts that we have discussed in the previous paragraph. But unlike futures, CFDs have no expiration date, have better liquidity to negotiate positions and have lower financing costs, commissions and opening fees than their counterparts. This positions them as the ideal product for retail investors to gain exposure to the oil industry.
Oil ETFs.
These products (which already we teach you in another article for your investment training) allow us to invest in the oil industry in a diversified way. Of course, this type of product does not take into account physical oil, it is normally based on the expiration of its futures contracts. Therefore, oil ETFs are based on the convergence between the future and expected value of oil. The best ETFs offering exposure to the oil industry are the Energy Selector Sector SPDR Fund (XLE), the Vanguard Energy ETF (VDE), the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), the iShares US Energy ETF ( IYE) or the iShares Global Energy ETF (IXC).
Main benefits of investing in oil.✅
Being one of the most demanded raw materials by the vast majority of global sectors and industries, oil is a good long-term investment. Its demand is inelastic, it generates very good returns in inflationary periods and at the same time it is a necessary good for economic growth. At the same time, as it is an asset class that has a lot of liquidity, if we invest in shares of companies in the oil industry, we can receive dividends that usually offer very good returns. Finally, it can also serve as a reference for trading currencies when news related to oil happens, as we explained in previous articles on the correlation of currencies and raw materials.
Main disadvantages of investing in oil.❌
As we have seen throughout this year, oil is an asset class that has a lot of octane, that is, it suffers from high volatility, so if we do not know well what this market bases its movements on, we can end up for losing against the market. At the same time, oil companies are subject to strict regulations by governments, which can also harm our investment in this sector. Finally, as we mentioned at the beginning of the article, the exploitation and transportation of this resource is prone to causing natural disasters, and in turn it is one of the main harmed by the transition policies towards cleaner renewable energies, established within the 2030 agenda against climate change.
Conclusions from this investment training on the oil industry.
After finishing this detailed investment training article on the oil industry, we are going to list the most important points. We have learned about the origin of oil, how it is extracted and what derivatives can be obtained. We have also seen the main producing countries and those with the most reserves globally and how it was discovered (from the Mesopotamian era to the modern era), as well as the different parts of the oil industry. At the same time, we have seen how the price of oil is defined and we have commented on two of the events that have impacted its valuation (as well as the influence of OPEC on its production and exploitation).
Most important events that have happened in the oil industry. Source: Bankinter.
Finally, we have discussed the different ways we have to invest in this industry and its main advantages and disadvantages when investing our capital. To conclude this investment training article on the oil industry, I remind you that before investing in any asset class we have to learn about its entire nature and behaviors, as we have compiled today in this great article (which I hope you have enjoyed and learned to the fullest).