Bill C. from Slidell, LA asks Hello Mitch, given that the war is probably going to last beyond this year, and with gas prices seeming like they will keep going up, I was thinking about buying more oil and gas companies in my portfolio. What are your thoughts on that?
Thanks for writing. Oil and gas stocks in the Energy sector have indeed been performing well this year, and the Energy sector as a whole has been outperforming all other sectors in the S&P 500 as well as the broad index. Energy was up +31.8% (total return) in the first six months of 2022, while the S&P 500 index was down -20%.1 That’s a huge gap.
In terms of your question about adding more oil and gas names to your portfolio, I have a few points for you to consider before moving forward. The first is how much exposure you already have to energy stocks, and whether adding names would skew your portfolio to be heavily concentrated in oil and gas. The Energy sector comprises 4.4% of the S&P 500 index, which is a good frame of reference for how much energy should be in a market-neutral portfolio. Assuming you want to be overweight energy, 4.4% of total liquid assets should be your starting point.
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The second point to take into consideration is that past performance does not predict future returns. So, just because Energy has had a stellar run over the last 6+ months relative to the broad market does not mean the outperformance will last indefinitely. Case in point: despite strong overall performance in the first half, Energy and commodities endured significant selling pressure in June, and Energy was the worst-performing sector for the month.
Natural gas prices, for instance, soared over 60% in April and May but plummeted in June to finish the quarter down -3.9%. Other raw materials suffered last month as well—wheat, corn, copper, and lumber prices all fell by double-digits, and oil fell sharply from early June highs. Supply and demand forces played a key role, but it also appears that markets were pricing-in a slower overall pace of global economic growth in the quarters ahead. If the global economy slows, demand for oil could soften from here just as U.S. producers are ramping up output.
A final factor to consider with regards to oil and gas stocks specifically is that the U.S. Energy Information Administration just released crude oil shortage data showing that inventories had actually climbed nicely earlier in July, which implies that new supplies are coming online at a faster-than-expected pace. We also know that Russian crude is still contributing to global supply, as they have found buyers in India and China. A combination of better-than-expected supply, moderating demand, and much of the war’s effect already being factored in to crude oil prices could mean waning enthusiasm for the Energy trade.
At the end of the day, having Energy exposure in an equity portfolio is crucial. But, I think it’s also important not to deviate too far from your benchmark’s weighting to the sector, so as not to introduce concentration risk in your portfolio.
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