Investing in oil stocks used to be a no-brainer. A growing world population and increasingly globalized economy required vast amounts of fossil fuels to heat homes, ship goods across the ocean, and fuel jet-setters' trips to that business conference in Tokyo. 

Things are a lot less certain for the oil and gas industry these days. Global oversupply of crude oil and natural gas, combined with fluctuations in demand, have caused the entire energy sector to significantly underperform the market in recent years. Major oil price crashes in 2014 and 2020 rocked the entire industry. And renewable energy continues to get cheaper and more widely used. 

Even so, an investment in oil can still offer value. You can invest in oil stocks by being aware of how oil prices are affecting the market and by focusing on dividends.

Keep an eye on the oil market

One of the biggest factors governing the oil industry is, of course, the price per barrel of crude oil. When crude oil prices rise, oil stocks tend to go up, too. When crude oil prices tumble, so will the prices of most oil and gas stocks. For example, when global demand for fuel crashed because of the COVID-19 pandemic, oil stocks were among the hardest hit. 

The reasoning behind this is pretty simple: The costs of getting oil out of the ground, transporting it, storing it, and refining it into fuel and other products are pretty fixed. When a barrel of crude oil can be sold for more than the sum of those costs, oil companies make money. But when oil is trading for less than the sum of those costs, at least some of those companies will lose money. 

It's generally better to buy oil stocks when oil prices are low and expected to rise, rather than when they are already high. However, the price of oil affects different types of oil stocks in different ways. Checking out where the price of oil has been and where it's likely to go is a critical first step in oil investing. 

A row of oil derricks.

Image source: Getty Images.

Know the differences among oil stocks

Not all oil stocks are created equal. In fact, "oil companies" may operate in entirely different parts of the industry. It's important to know what kind of company you're investing in before you buy.

  • Upstream companies, also known as exploration and production companies or simply E&Ps, explore locations around the world for oil, and, once they discover it, drill wells to extract it from the ground or seafloor. They are most susceptible to fluctuations in the price of oil. The largest E&P in the U.S. is ConocoPhillips (NYSE:COP).
  • Midstream companies transport crude oil through pipelines and store it in terminals while it's waiting to be refined or exported. Many also transport refined products through their pipeline networks. Since midstream companies often operate their networks through fixed-rate, long-term, or take-or-pay contracts, their operations can be somewhat insulated from oil price fluctuations. Master limited partnership Enterprise Products Partners (NYSE:EPD) is a major midstream company. 
  • Downstream companies refine crude oil into other products like fuel or petrochemicals, or sell refined products to consumers. Some do both. Gas station operators and refinery operators both count as "downstream" companies. The price of oil often has minimal impact on refineries' profitability, because they make their money on the "crack spread": the difference between the price of oil and the price of refined products. Such stocks still often take a hit when oil prices fall. Phillips 66 (NYSE:PSX) is a major downstream company. 
  • Integrated companies operate in more than one of the above fields. The so-called "integrated majors," sometimes referred to as "Big Oil," have large upstream and downstream operations, and some midstream capability as well. ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) are two such oil majors.
  • Oilfield services companies provide equipment, operational support, and logistics to upstream companies. These can include onshore or offshore drilling rigs, drill bits, subsea robots, or pressure valves. When oil prices are low, upstream companies often try to cut their services costs, which hurts oilfield services companies. Since 2014, most have been poor investments, and they are probably best avoided by beginning energy investors.
  • Oil ETFs allow you to invest in an entire subsector of the oil industry at once, as opposed to a single oil company. ETFs, or exchange-traded funds, are traded much like oil stocks. One noteworthy oil ETF is the SPDR Oil and Gas Exploration & Production ETF, which tracks the upstream subsector as a whole.

Focus on the dividend

Oil companies' struggles don't seem likely to disappear anytime soon. Even if they go through a period of short-term calm (such as the period between 2017 and 2019), global events outside their control can set them back on their heels quickly. That's why, for long-term investors who don't want to have to constantly monitor the oil markets, dividend investing is probably the best choice here.

Integrated oil companies ExxonMobil and Chevron have been increasing their dividends annually for decades, with management prioritizing dividend preservation. Likewise, many midstream companies -- especially those with a master limited partnership (MLP) structure -- offer high yields and sustainable payouts. 

When you're evaluating an oil company's dividend, don't just look at the yield (for which a higher percentage is better); compare the yield to the company's free cash flow. The best companies will be able to pay their total dividend obligations (plus capital expenses) out of free cash flow with some left over. A "payout ratio" of 1.1 times is considered good, and 1.2 times or more is considered outstanding in this industry.

How to invest in oil stocks with little money

Oil stocks run the gamut from large to small, and the share prices of oil companies are similarly varied. For example, just among the integrated majors, prices have ranged from as little as $15/share all the way up to more than $100/share.

If the stock you like is too expensive for you, buying fractional shares -- that is, less than a whole share of a stock -- is a great way to invest. However, if you're investing in a dividend stock, make sure you check up on your broker's policy regarding dividend payments to fractional shareholders. 

Regardless of the size of your investment, it's important for you as an oil investor to be aware of what's happening in this volatile and cyclical sector if you hope to fully maximize the potential of your energy portfolio.