Wall Street Is Steadily Investing In Energy As An Inflation Hedge

At the end of last week, fund managers had built up the largest net long position in crude oil futures in nine months, according to data from the Commodity Futures Trading Commission. It is serving as a necessary inflation hedge given a growing conflict in the Middle East, and declining drilling at home. The biggest risk to equity returns remains inflation and funds need to protect themselves. Inflation also risks prolonging the current period of high rates, which is already taking its toll on several asset classes, including housing. Oil and energy equities broadly are increasingly appealing as a result of these dynamics.

Funds flow into energy is expected to continue and the recent involvement of the U.S. in Iran will only accelerate this move. In the latest Bank of America fund manager survey, energy and materials still remained unloved, with managers net underweight. This is even after the recent increase, as allocations were near record lows just earlier this year.

Yield and an inverse correlation to bonds has been another benefit of the trade. The yield on XLE, the energy sector ETF, is also almost three times that of the broader market, providing income that closer tracks inflation. It has also been performing as a hedge when bonds, the historical hedge in the 60/40 portfolio, have been failing. Periods of increased inflation expectations, as seen with the initial tariff announcements, now see both bonds and equities dropping in parallel. This is because inflation would force rates to remain high right as the U.S. refinances a sizable chunk of government debt this summer. The already large deficit means that higher rates become a self-fulfilling problem as more and more of future bond raises goes towards paying interest, which investors demand a higher rate for, creating a growing deficit spiral in an inflationary environment.

The above strategy has played out in actual returns. US equities are up only slightly this year, a little over 1%, while emerging markets and commodities have outperformed, with gold up over 25%, oil up over 5%, silver up over 20%, emerging markets up over 10%, and bonds returning a little less than 1%.

Several other dynamics make continued energy outperformance, and increased fund exposure likely, and these are outside of the increasing conflict in the middle east. The first is that escalating equipment costs, due to a combination of climbing labour costs and changing supply chains, benefits incumbent energy names. The second is that power demand shows no signs of slowing down with natural gas being the winner in AI data centers that require both scale and reliability. This is also during a period that the US wants to continue to grow natural gas exports, creating multiple demand levers at a time when storage availability remains flat. That creates an asymmetry where prices can spike to the upside. The third is that oil rigs have dropped by 9% in the U.S. as producers pulled back capital amidst economic uncertainty. This reduces the chance that supply will overwhelm demand and helps alleviate some of the downside risks to the trade.

While energy investing always has a risk, an allocation as a hedge, especially given the broader macro tailwinds, is increasingly appealing for funds. This continues to show up in recent funds flow and is expected to only increase this coming week with both energy equities and oil prices likely to spike on the news of U.S. strikes.