Surging oil prices following Russia’s invasion of Ukraine in late February sparked broad-based stock selloffs around the world. Investors reacted immediately, concerned that limited energy supplies and higher costs could exacerbate inflation, then jumped back into stocks just as quickly when oil prices began ticking down.
This pattern of volatility driven by short-term swings in oil prices has continued since the start of the conflict, demonstrating the impact of oil prices on investment portfolios. But investors with more direct exposure to energy-related sectors through commodities and infrastructure strategies likely had a different experience — and may have different questions about what comes next.
Recent performance by natural resources and infrastructure investments have illustrated the important role these strategies can play in a diversified portfolio. But investors should also avoid the temptation to overreact to short-term conditions and make dramatic moves that can expose them to higher risk over the long term.
Although infrastructure funds include investments related to the oil and gas industries, their returns typically aren’t directly connected to the prices of those commodities. For example, oil and gas pipelines are paid based on the volume of product moving through their networks — regardless of commodity prices. Utilities that face higher prices for the fuels they use to generate electricity generally are allowed to pass those costs on to their rate payers, keeping their cash flow more predictable in volatile energy markets.
So while high energy prices are unlikely to produce excess returns for infrastructure strategies, they’re also unlikely to suffer as much as other equity investments during market downturns sparked by surging oil prices. That’s why infrastructure funds often serve as defensive strategies, particularly as a way of offsetting volatility elsewhere in a portfolio.
One of the primary reasons investors choose real asset strategies is to provide an inflation hedge in their portfolios. Companies directly involved in extracting commodities like oil and gas from the ground — as well as agricultural products, metals, timber and water — should benefit when the price of these economic building blocks rises dramatically.
Companies directly involved in extracting commodities like oil and gas from the ground — as well as agricultural products, metals, timber and water — should benefit when the price of these economic building blocks rises dramatically.
The recent spike in oil and gas prices showed this principle in action: The energy component of the U.S. Consumer Price Index increased 32% year-over-year in March 2022*, which is translating into rising cash flow and profits for oil and gas producers. At the same time, natural resources strategies that invest in these companies have widely outperformed the broader market.
In the short term, natural resources strategies with exposure to oil and gas producers have been performing as expected in times of high energy prices and high inflation. In the medium term, the lack of excess production capacity in the global energy markets and the complexity required to accelerate the world’s transition to a low-carbon economy may keep energy prices elevated — barring a recession or other macroeconomic catalysts that reduce demand.
Despite the dramatic impact of recent energy price movements on the equity markets, investors should be cautious about making short-term, tactical movements in their portfolios. We believe that long-term investment success depends on proper diversification across an entire portfolio, as well as within the individual strategies used to achieve an investors’ desired exposures.
For example, a commodities strategy heavily concentrated in oil and gas producers that may have delivered higher returns during February and March of 2022 is subject to higher risk of losses when demand for energy declines. A well-diversified natural resources strategy that includes exposure to other important sectors can provide the inflation-hedging and return potential that investors seek, without taking additional risks related to an energy sector that’s still in the midst of a long-term transition.
Likewise, infrastructure strategies should balance investments across sectors to avoid concentration in energy-related industries like pipelines and utilities. Geographic diversification can also reduce risks related to regulations, political activity and natural disasters.
No one can predict what may cause the next energy shock, or how the economy may adjust to these events over the long-term. Choosing well-constructed, well-diversified real asset and infrastructure strategies can help investors increase the odds of achieving their goals under a broad range of circumstances.
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Cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows.
S&P 500 is the Standard & Poor’s 500 Index, is a float-weighted index, meaning the market capitalizations of the companies in the index are adjusted by the number of shares available for public trading of the 500 leading publicly traded companies in the U.S.
*U.S. Bureau of Labor Statistics, Consumer Price Index News Release, March 10, 2022.
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