Summary

• Energy was the second-best-performing sector in 1Q24 but had fallen to the worst-performing sector in September as the outlook for oil prices deteriorated.
• Iran launching missiles at Israel heightened oil supply risk, causing oil prices and energy equities to rally.
• Given greater geopolitical risk, investors may want to reconsider their energy allocations, particularly if currently underweight energy.

It’s been a rollercoaster year for oil prices and energy equities. Energy had been a fairly sleepy sector for much of 2Q24 and 3Q24, but geopolitics have brought energy back into focus in recent days. Against the backdrop of increased geopolitical risk, investors may want to revisit their energy allocations to ensure their exposure is meeting their needs.

Energy Stocks: Strong Start Turned to Doldrums, Geopolitics Provide Wakeup Call

A strong start saw double-digit percentage gains for both oil prices and the energy sector in the first quarter. Though hard to believe now, energy was the second-best-performing sector in the S&P 500 in 1Q24.  WTI crude hit its high watermark for the year in early April near $87 per barrel (bbl).

Then, oil prices faded given ample supplies and rising demand concerns, particularly related to China. Natural gas prices in the US were also weak. Energy stocks retreated and growth sectors commanded more attention as the market waited for the Fed to lower interest rates.

In September, OPEC+ decided to delay their unwind of production cuts that had been planned for October given a subdued oil outlook. Energy was the worst-performing sector in the S&P 500 year to date, and oil was meandering in the high $60s/bbl. Financial positioning in petroleum futures and options contracts was at record levels for bearishness at times in September.

On October 1, Iran fired numerous missiles into Israel for the second time this year. The downward slog in oil prices quickly reversed as the market weighed Israel’s potential response and any impact on Iran’s energy infrastructure. Oil prices gained over 5% on October 3 after President Biden made comments about Israel targeting Iran’s oil assets in response to a question. The next day the President seemed to discourage attacks on oil fields.

Overall, oil prices jumped more than 13% from September 30 to October 7, likely helped in part by short covering. The Energy Select Sector Index (IXE) gained 6.5% over the period. Energy stocks became topical again as they proved their muster as a geopolitical hedge.

Oil Supply Risk Rises with Iran’s Involvement.

While tension in the Middle East has been heightened since October 2023, oil supply had not been impacted. Iran’s direct involvement put its supply at potential risk, as well as the broader volumes shipped through the nearby Strait of Hormuz. Per Bloomberg, Iran produced 3.3 million barrels per day (MMBpd) of oil in September and exported 1.7 MMBpd. Just over 20% of the world’s oil supply moved through the Strait of Hormuz in 2023.

WTI oil has pulled back from the relative high of $77/bbl at the close on October 7, but the geopolitical backdrop remains tenuous as the world awaits Israel’s response. Oil prices could continue to moderate if the geopolitical situation deescalates given comfortable supplies and the prospect of OPEC+ returning barrels to the market. However, a broader conflict could continue to put upward pressure on prices, especially if the spare production capacity in this region is not accessible.

 What are Investors to do?

With this backdrop, how should investors be thinking about their energy allocations? For investors simply trying to match the energy exposure in the S&P 500 (energy currently at a 3.4% weight), the answer may be to do nothing. For investors that are underweight energy, geopolitical risk may merit consideration of at least a market weighting. Keep in mind that the S&P 500 was down as oil and energy rallied at the start of the month as shown below.

For investors that want to add to their energy exposure, there are different approaches to consider beyond a default allocation. If one wants more exposure to oil prices to hedge geopolitical risk, then it would be best to focus on oil and gas producers. When oil jumped at the start of October, the Alerian Texas Weighted Oil & Gas Index (ATXWO) gained 9.7%, outperforming the IXE. ATXWO is an index of energy companies that produce oil and gas in Texas (read more).

If investors want energy exposure but are concerned about oil prices potentially retracing if tensions subside, it may be best to consider midstream. Midstream companies operate pipelines and other energy infrastructure for fees, which results in stable cash flows and relative insulation from commodity prices. Midstream corporations and MLPs have seen strong performance throughout this year, even as oil fluctuated (read more).

The Alerian Midstream Energy Select Index (AMEI), which is 75% US and Canadian Corporations and 25% MLPs, gained 3.4% as oil jumped but is up over 30% year-to-date on a total-return basis through October 7. Similarly, MLPs represented by the Alerian MLP Infrastructure Index (AMZI), gained 1.2% but have year-to-date total returns north of 20% as of October 7. Midstream’s fee-based business model also supports healthy dividends. AMEI and AMZI were yielding 5.4% and 7.2%, respectively, as of October 10, making midstream an attractive option for investors wanting energy exposure and income.

Bottom Line:

Energy stocks can be an effective geopolitical hedge, and recent events may be reason to reconsider an energy allocation. Investors looking for more energy exposure may want to consider a more tailored approach instead of a generic broad energy allocation.

Related Research:

Which Energy Subsector Is Up Over 20% YTD?

Looking for Exposure to Oil & Gas Producers? Try Texas

ATXWO is the underlying index for the Texas Capital Texas Oil Index ETF (OILT). AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR) and the ALPS Alerian Energy Infrastructure Portfolio (ALEFX).

vettafi.com is owned by VettaFi LLC (“VettaFi”). VettaFi is the index provider for OILT, AMLP, MLPB, ENFR, and ALEFX, for which it receives an index licensing fee. However, OILT, AMLP, MLPB, ENFR, and ALEFX are not issued, sponsored, endorsed, or sold by VettaFi. VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of OILT, AMLP, MLPB, ENFR, and ALEFX.

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