Tuesday, October 9, 2007

Oil ETF and Stocks

Just last week, we were discussing about Exchange Traded Funds (ETF) and its use. Mainly, to save commission cost and reduce volatility. There are, however, instances where buying ETF will enhance your return compared to buying one individual stocks. Buying Oil ETF and its corresponding stock is one example.

Oil stock, by definition, is shares of a company which engages in the oil production, exploration, distribution, refinery or other related oil expertise. Out of this sector, only stocks that engage in oil production will move in tandem with the rise and fall of oil price. The reason is simple. They drive their profit based on the average selling price of oil for the particular month or year. If the cost of extracting a barrel of oil is $ 20 and current oil price is at $ 50/ barrel then, $30/ barrel is the company's gross profit. If oil price moves downwards, their profit will be reduced as well.

Now, what happens is an oil producing company does not always produce the same barrels of oil each time. Weather, political reasons and other outside factors may play a role in this. Thus, for example, when oil price rises from $ 50 to $ 70/ barrels while production fell, the profit generated by this oil company is not directly proportional to the increase in oil price.

Therefore, if you feel that oil price will move up in the coming years, what should you do? Buying an oil company will generally expose you to company specific risk and some will give you higher returns than oil price appreciation, some don't. This is where Oil ETF comes into play.

Oil ETF will move in tandem with oil price. If oil rises by 20%, then its corresponding ETF will move by the same amount. Thus, this makes it easier on investor. They do not have to figure out both oil price and the company specific issues such as production, cost of extracting oil or even labor unions.

What oil ETF can you buy? There are two ETFs available for US investors; United States Oil (USO) and iPath Goldman Sachs Crude Oil Index (OIL). You could probably choose OIL, which is trading at a lower price than USO. It doesn't matter, however, as they normally moves in similar fashion and your return would not be affected by which ETF you choose.

Novice Investing is the online investing guide for beginners. You can also submit investing articles here