Tilting Toward Energy

Tilting Toward Energy

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
March 23, 2011

Key Points

• Despite dramatic current events impacting markets, tactical shifts to your energy-sector allocation could add a small performance boost over the next several months.
• Volatility will likely remain elevated as events unfold in the Middle East and recovery continues from the devastating disaster in Japan.
• For investors looking to make shorter-term, tactical adjustments to a portfolio.

Whether you're looking at the latest newspaper headlines or watching cable news, there's a lot going on to make investors nervous. How might you adjust your portfolio mix in light of increased geopolitical tensions centered in oil-producing areas of the world, the tragedy in Japan, and escalating inflation fears?

If you're looking to make shorter-term adjustments to your portfolio—tactical shifts—we believe increasing your allocation to the energy sector may boost your performance over the next several months. A note of caution, however: This does not mean going whole hog into energy, but rather allocating a few percentage points more of your stock allocation to the sector.

It may also take a bit of a strong stomach over the next several months to be investing in energy. Volatility will likely remain elevated as events unfold in the Middle East and recovery continues from the devastating disaster in Japan.

Strong demand likely to continue …
We've seen the price of oil pull back after the earthquake and tsunami as concerns grew that the world's third-largest importer of crude would see demand lessen. While that's probable to a small extent, we believe it's a short-term phenomenon, and that an easing of prices should help keep global demand solid.

We'd moved the energy sector to an outperform rating before the tensions began to escalate, and we believe the underlying story remains firm. The world economy is now solidly in expansion mode, which likely means an increase in demand for energy—especially in the all-important United States and China. Encouragingly to us, China has been tightening monetary policy, but its demand for energy has remained solid, and the energy sector appears to be taking the tightening action in stride.

Additionally, adding to the energy supply is certainly possible in the longer term should regulations loosen in the United States, but in the near term it seems unlikely that a large amount of new drilling will be allowed—helping keep new supply limited. Certainly there's an element of speculation that's keeping the price of oil elevated, but with global tensions likely to remain heightened, we don't see that premium being pared back to any great degree in the near future.

… but risks do remain
There are, of course, risks to the sector, which is one reason we continue to advocate a diversified portfolio. The largest risk we see right now is demand destruction due to ever-higher prices. At some point—likely if we were to approach $150 per barrel in the near term—economies around the world would slow down, as prices at those levels would be a substantial "tax" on nations.

As a result, energy demand would likely be pared back, resulting in declining prices and at least a short-term period of underperformance for energy stocks. We don't believe this is an overly large risk, however, as The Organization of the Petroleum Exporting Countries (OPEC) has indicated that it recognizes that risk and stands ready to increase supply if needed to limit price gains.

Instead of fearing the increase in energy prices and the geopolitical situation, we suggest you attempt to use some tactical adjustment to try to make money on the increased fear and uncertainty. And with more sector-specific investment vehicles available, increasing your allocation to the energy sector in a diversified way is open to more investors.

Important Disclosures

Due to the sector focus of this strategy, investors may experience greater volatility than investments with a broader investment strategy. This strategy is not intended to serve as a complete investment program by itself.

Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

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