Oil and your portfolio

Some of the world’s greatest fortunes have flowed from the ground, one barrel at a time. Oil powers cars, trucks, jet engines and generators. In many ways, it has powered the entire modern economy as we know it. But will that always be the case? Or is oil on a slippery slope down the industrial food chain?

The primer

Oil has been an indispensable commodity since the 19th century. It is the world’s cheapest mass energy source. Competition from alternative energy sources is gaining momentum, but the competitors are still years away from the scale necessary to bump oil aside. Nonetheless, be very careful about how much oil is in your portfolio; its economic role is on a slow decline.

How to invest in oil

There is a dramatic difference between investing in oil products and oil the commodity. To invest in the commodity means futures contracts and derivatives.  To invest in oil the product means stocks and bonds of oil companies, and possibly companies that make drilling equipment or participate elsewhere in the oil supply chain. Individuals are best off using oil-related stocks and bonds; futures and derivatives can ruin your risk budget.

How much oil in your portfolio?

For most investors, we recommend a “market weighting” for oil as a portfolio component. That means that if oil stocks comprise five percent of the value of all stocks, then you should have about five percent of your portfolio in oil stocks.  Any more or less means you are taking a bet on the future price of oil, a very tough bet to win and one that is potentially costly to you.

Predicting the price of oil is tricky business; even experts who study the oil market all day every day have a dismal prediction record. Most are super bulls who count on a one-way street. Remember oil at $150 a barrel predicted by Goldman Sachs? Or Daniel Yergin’s peak oil? Or OPEC’s relentless price increases until they shifted to price cuts?  Following the advice of oil experts can be harmful to your financial health. Predicting on your own is even more perilous.

Oil and its effect on our economy

In the House of Morgan where I grew up as an investor, we welcomed each oil price drop. The US was an oil importer. A drop was like a global tax cut – every user of oil suddenly had more available cash. Although it might hurt oil producers, a price decrease stimulates the rest of the economy. Consumers, industry, transportation…they all benefit. Overweighting oil stocks is really a bet against the rest of the economy.

The future – oil and renewables

The dominance of oil is slowly waning. But that doesn’t mean the end of the sector by any means. Expect any big oil company to evolve, diversifying and expanding through renewable energy including solar, wind, tidal and others.

Eventually, solar may be cheaper than oil. It makes sense. Oil is getting harder and more expensive to find and deliver. Popular opinion is shifting away from fossil fuels. Solar, wind and tidal offer essentially limitless supplies of clean, socially acceptable energy. Oil stocks still trade predominantly on the volatile price of oil, but there may come a time when they trade on the price of renewables. In any case, the value of oil is going down.

Winners and losers

Although an oil price drop is positive for the economy and for consumers, not everybody wins. Straight commodity oil producers lose the most. Dirty energy substitutes like coal are a close second. Natural gas does poorly. Energy-rich geographic areas and their infrastructures suffer. Users of oil benefit, of course. For investors, a risk-balanced diversified portfolio should do fine in an oil decline since there are so many offsetting positives.

Observation and conclusion

You can argue all day long about the vices and virtues of oil, but the fact is oil as an investment is getting smaller. It has been for some time. Oil is a commodity and fluctuates in price according to demand. Like any commodity, oil has no intrinsic price and pays no dividend. It is only worth what the latest buyer is willing to pay for it. Saudi Arabia is preparing for a future of smaller oil. In our view, investors can do the same. Contact us if you want to know how we are doing it.

Research shows that only 1/3 of investors are currently comfortable with their investment portfolios. If you’re interested in a free performance review, click here.