Investing in oil relies on more than just consumer demand. You’ll contend with high day-to-day volatility that attempts to price in weather-related supply disruptions, OPEC price-setting, plus the fortunes of individual small or medium-sized oil producers.
For investors looking to increase their portfolios’ exposure to crude, buying individual stocks is one of several options. While large producers may afford more stability for investors, they’re unlikely to generate the type of return an investor may hope to receive from a speculative oil investment.
And while small and medium-sized oil stocks could generate higher returns, they’re also more susceptible to sustained depressed oil prices, which OPEC has been known to promote in order to squeeze out smaller U.S. domestic energy producers. Given these risks, picking the stocks that are most vulnerable to the whims of the market and those that represent growth opportunity can be a struggle.
Therefore, if you believe in the long-term prospects of oil and oil stocks, the best way to play them is through LEAP options. LEAPs stands for Long-term Equity Anticipation Securities. LEAPs are options that have several years until their expiration and are available for most indexes and stocks.
So if you feel that the price action in oil stocks has gone too far and that, long-term, the fundamentals are strong for the oil sector, you could buy an option that expires in January of 2023.
As I said, figuring out which stocks are most susceptible to this fall in the price of oil is difficult. So if you want to put on a bullish trade in the oil sector, I would recommend using ETFs such as the Oil Services ETF (OIH) or Energy Select SPDR (XLE). When buying the ETF, you get exposure to a wide group of oil stocks rather than taking on the risk of choosing just one or two stocks.
For example, here are some of XLE’s holdings and weightings:
Chevron: 24.08% weighting
ExxonMobil: 21.81% weighting
ConocoPhillips: 4.58% weighting
Schlumberger: 4.31% weighting
So, as an example, if you wanted to buy a LEAP on the XLE, you could buy the XLE January 30 Call that expires in January 2023 for $7.70. This option gives the owner of the call just over two years for oil and oil stocks to rebound.
While the LEAP option doesn’t reduce the intrinsic risks of investing in oil, such as depressed consumer demand, OPEC pricing pressure, or a fundamental shift to green energy, it does reduce your exposure as an investor. The option investment gives you comparable upside exposure to oil while reducing your maximum risk and your capital outlay. Because this is an option trade, your purchase price will include a time and volatility premium, which is best considered the price paid for the aforementioned lower maximum risk and initial investment.