We've all experienced first-hand how instability in geopolitics can impact our portfolios and everyday lives. In early 2022, Russia’s invasion of Ukraine was the most stark example of how a single unexpected event can cast turmoil on the commodities markets and unleash volatility in global stock and bond markets. The result was a spike in inflation, but maybe the more lasting impact will be a rethinking of how multinational corporations conduct business.
Energy independence is now front and center for nations and companies alike. But what other impacts are felt on the energy markets from geopolitical unrest? Perhaps more importantly for individual investors, what can be done to mitigate the risks and even capitalize on this uncertainty? Allio’s investment team sat down to strategize just that.
Zig When the Market Zags
For starters, we must think big picture and stay a step ahead of markets. Like hockey-great Wayne Gretzky would quip, “You must skate to where the puck is going, not where it has been.”
We cannot simply follow the headlines and expect to keep portfolios safe from geopolitical risks. In this case, the writing on the wall is that there could be what is known as a “bullwhip effect” affecting energy markets. While it sounds like a term you would hear in Econ 101 or 201 class, it makes intuitive sense. The bullwhip effect boils down to firms and countries over-correcting for a prior problem.
Fears of not being able to procure enough energy supply could lead to a short-lived glut in some markets, causing prices to drop. Individuals experienced this back in 2020 when fears of a toilet paper shortage led to folks hoarding the product, and then having too much of it. The economic phenomenon basically states that when there’s an extreme shortage (or the perception that there will be one), then an oversupply could happen next. We have already seen this play out in some markets such as lumber and even more recently in egg prices.
Energy Market Volatility: Front and Center
For oil and gas, price swings have been dramatic as well. Oil traded to nearly $130 per barrel at times in 2022 but then declined sharply back into the $70s. Natural gas, meanwhile, surged to $10 in the U.S. then collapsed to briefly fall below $2. Overseas, European natural gas rocketed to more than 300 euro/MMBtu before plunging to below 60 euro. The bottom line here is that geopolitics causes volatility in energy markets and across all commodities.
Investors must prepare for more of that so long as tensions persist. A prudent strategy is to take profits when sudden surges take place, then boldly buy the dip after the price collapses. Easier said than done, but always keeping an open mind in markets is critical. What’s more, you must remain disciplined when the TV headlines clamor about oil going to $300 or natural gas surging to more record highs – it is times like that when there’s probably more downside price risk than further upside.
Other Ways to Invest During Troubled Geopolitical Conditions
It's not all about commodity markets, though. In fact, commodities are actually a small part of a balanced global macro portfolio. More important decisions may involve overweighting or underweighting certain countries or regions depending on the state of the energy markets and geopolitics.
For instance, if the market has settled down and a period of complacency has settled in, it could be a time to put on a tactical long position in an energy-producing nation such as Canada or Saudi Arabia. We can even go more macro with a broad position in, say, South America which is also resource-rich. History shows that when oil and gas prices shoot up, those areas tend to benefit. Moreover, lightening up on areas that depend heavily on energy imports would be another way to play that thesis.
And then there is the obvious strategy of simply buying shares in the domestic energy sector via a low-cost exchange-traded fund (ETF) and then moving on to other portfolio decisions. But the not-so-obvious way to take advantage of rising energy prices due to geopolitical conflicts across the globe would be to take a small portion of a portfolio and speculate in volatile electric vehicle (EV) equities. After all, EVs act like a substitute for traditional autos, so higher prices at the pump make EVs all the more attractive.
Assessing Energy Sector Stocks
Those are all short-term tactical ways to capitalize on tailwinds in the energy market. But let’s think more broadly and determine how energy stocks should fit in your portfolio. As it stands, valuations among oil and gas names are quite cheap compared to history. Getting into the finance weeds here, as we do at Allio, the sector trades at just 10 times next year’s earnings per share. Contrast that to the broad market selling for a lofty 18 times. That’s a huge gap that favors the energy sector on a relative value basis. This niche of the S&P 500 comprises companies with ample free cash flow (a measure of true profitability and cash available to distribute to shareholders) and high dividend yields. We like those kinds of investments!
Moreover, management teams at energy companies have gotten their acts together when it comes to capital spending – they used to invest willy-nilly on any speculative well project (called “wildcat wells”) back in the late 2000s and early to mid-2010s. You see, it is not just the numbers that make an ideal long-term investment, but also qualitative variables like the discipline of a firm’s management. It’s our job as portfolio managers to stay on the ball though – high times in the energy market can cause a CEO and CFO to get too aggressive.
Keeping an Eye on Geopolitical Developments
You’ll notice that we focused heavily on the “how” of investing in energy during geopolitical turmoil. We are not as concerned about becoming geopolitical experts and wartime strategists. But there are still broader impacts that may exert pressure on economies.
Geopolitical uncertainty adds a layer of uneasiness to global investing. Parking dollars in a set-it-and-forget-it approach is harder to do when we see oil production being disrupted and prices rising at the pump and grocery store. Investing during these inflationary times requires a solid understanding of intermarket dynamics.
2. Sanctions and trade wars
Sometimes it doesn’t require a traditional war to cause a dramatic change in the energy markets. Take the financial trade disputes that began even before Russia’s invasion of Ukraine and Covid. A focus on domestic oil and gas exploration and production led to, arguably, a bearish supply-demand imbalance and exceptionally low prices in the U.S. At the same time, sanctions imposed on Russia in 2022 helped send oil, gas, and even power prices through the roof.
3. New alliances
We’ve seen some countries shun others and foster new partnerships in an effort to stave off the risks from volatile energy prices in the last several years. Look no further than what is happening with OPEC (the Organization of Petroleum Exporting Countries) which has eased its policies to allow member nations to coordinate production plans. That development has effectively led to a more free oil market. OPEC thus has less control over the supply-demand dynamics compared to past decades.
4. Capital investment
Infrastructure is also at-risk during periods of geopolitical stress. Just take a look at the headlines when Putin was threatening Ukraine and Europe in 2022. The Nord Stream 2 pipeline was in focus as much of the European continent depended on it for energy. Fears were that a limited supply of oil and gas during the winter, resulting from a possible shutdown of the pipeline, would not only send prices to the moon but also endanger lives during the depths of winter. Luckily, that did not play out, but it was a key risk. Looking forward, European legislators may take faster steps to reduce the area’s dependence on foreign energy. We’ll see how that plays out.
The Bottom Line
Geopolitics is always a wild card in the investing landscape. It is hard to predict when the next major conflict will ensue and how traders will react. Thus, keeping a longer-term focus while making tactical investment decisions is the way to go about reducing risk and capitalizing on volatility.
You can invest alongside Allio’s team of hedge fund veterans who have been through many periods of global economic uncertainty along with both bull and bear markets in the energy industry. Our next-gen finance app makes building a global macro portfolio and growing your net worth easy.