Oil ETF: What It is, How it Works, and Challenges

What Is an Oil ETF?

An oil ETF is an exchange-traded fund (ETF) which invests in companies engaged in the oil and gas industry. Companies featured in the ETF basket include discovery, production, distribution, and retail businesses as well as the commodity itself. Some oil ETFs may be commodity pools, with limited partnership interests instead of shares. These pools invest in derivative contracts such as futures and options.

Understanding an Oil ETF

An oil ETF offers advantages to those wanting to participate in oil markets and reap the potential profits without the logistics of handling single energy-related stocks. Like mutual funds, an exchange-traded fund will track an index, a commodity, bonds, or a basket of assets. Unlike mutual funds, an ETF trades like a common stock on an exchange. They experience price fluctuations throughout the day so have higher daily liquidity. Also, they frequently have lower fees than mutual fund shares, making them an attractive alternative for individual investors.

Most investors, especially individuals, cannot obtain and store physical supplies of crude oil nor would they want to do that. However, the volatile oil industry is a favorite investment and trading sector. With an oil ETF, the investors are not dealing in futures, so physical inventory isn't a concern. This option provides a convenient way for investors interested in getting into the oil market to participate.

The benchmark target for an oil ETF may be a market index of oil companies or the spot price of crude itself. Funds may focus on only United States-based companies or may invest around the world. There are even inverse ETFs for oil and other sectors. Inverse securities move in an equal and opposite direction to the underlying index or benchmark. Oil ETFs will attempt to track their relative index as closely as possible, but small performance discrepancies will be found, especially over short time frames.

Investing Challenges of Oil ETFs

Oil ETFs have a high level of demand from investors because oil is such a pervasive commodity in the modern global economy. This investing trend is only likely to increase. Almost every end product used by people, companies, and governments is in some way affected by the price of oil, either as a raw component or through the costs of energy, transportation, and product distribution.

However, investing in oil ETFs can be tricky and complicated. Many fluctuating factors impact the market, and these conditions can be difficult to predict. The market is continually adjusting, and global political events and environmental conditions have significant, and unexpected, effects on the market.

There are many oil-based ETFs available for investments. Research and comparison of the expenses and results of the available funds are critical before investing. Some of the most significant oil ETFs in the U.S. marketplace include: 

• United States Oil Fund (USO) seeks to follow the daily changes in the spot price of light, sweet crude oil for delivery at Cushing, Oklahoma and follows the Benchmark Oil Futures Index.
• Vanguard Energy ETF (VDE) uses an indexing approach to track the MSCI US Investable Market Energy 25/50 Index with the stocks of large-, medium-, and small-size U.S. companies.
• Alerian MLP ETF (AMLP) invests at least 90% of funds in the assets included in the Alerian MLP Infrastructure Index made up of transportation, processing, and storage of energy commodities.
• Energy Select Sector SPDR ETF (XLE) seeks to replicate the Energy Select Sector Index by investing at least 95% of the funds in oil, gas, consumable fuels, and energy equipment and services companies.

The Bottom Line

Oil ETFs are exchange-traded investments that a basket of oil-related instruments, such as securities in oil companies or petroleum commodities. These can be easily traded, like a stock, but have the advantage of more diversification than investing in a single security.