Investing amid higher-for-longer oil prices

What we mean by “higher for longer.” Our base case doesn’t define “higher” oil prices as the extreme levels that recently approached $130/barrel. Nor do we equate “longer” with indefinitely. On 10 March, the forward price curve for West Texas crude showed $113/barrel for April, dropping to $89 for December (Figure 1). But even such a sharp decline would see oil ending the year in the $80-$100 range — well above the $50-$70 that prevailed for much of the past five years, and still contributing to stronger overall inflation.?

Boosting supply and tamping demand are far easier said than done. Oil and other commodity prices had been trending steadily higher well before Russia’s attack on Ukraine, driven by already-tight supplies and roaring demand, along with geopolitical jitters leading up to the invasion. Oil producers have been quite disciplined in limiting output, and even if they wanted to ramp up production, it would take too long to help alleviate shortfalls. Meanwhile, even with dramatically higher prices, demand shows no signs of abating — especially in the U.S. and other developed nations where energy costs claim a relatively small share of wallet (Figure 2).

The spike in oil prices doesn’t signal an imminent recession. Soaring energy costs often precede economic downturns, but it’s not a cause-and-effect relationship. That said, the continuing run-up in oil and other commodity prices has important portfolio construction implications. We see opportunities among U.S. energy companies, commodity-exporting countries and regions, and asset classes that typically perform well in inflationary environments, including various commodity sectors and income-producing real assets.

What does this mean for portfolios?

U.S. energy companies should continue to exhibit momentum. We still favor U.S. companies with pricing power, the most obvious being energy companies that benefit from higher oil and gas prices.?

While rising energy costs may put a dent in discretionary spending, they’re not likely to derail it altogether. Given the resilience of the U.S. consumer, we think consumer discretionary companies that are less tied to energy, such as brand and market share leaders in athleisure, warrant a closer look. We also continue to eye value opportunities in software names that have borne the brunt of higher interest rates this year.?

Country and region selection should play a greater role. The likelihood of performance dispersion across countries and regions has perhaps never been higher. Investors who can find opportunities among commodity exporters in both developed and emerging markets should come out ahead. Potential beneficiaries of higher commodity prices include the U.K. and Canada in developed markets, and Mexico and Brazil in emerging markets.?

Diversify your inflation protection. Supply-constrained commodities are so far holding their gains in energy, metals and agricultural markets such as grains and oilseeds. We also think it’s prudent to diversify traditional inflation hedges with real estate and infrastructure projects that may be less prone to price swings and better able to generate income that can keep pace with inflation.?

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