Why Oil & Energy Stocks Deserve a Place in a Diversified Portfolio Today

By Rayna Penelova on July 3, 2025

A portfolio is a collection of assets designed for a specific purpose.  In our view, there are several important considerations when adding a position to a portfolio. For example, how is the position expected to contribute to the risk/reward dynamics of the overall portfolio?  Do we think it adds octane and has the potential to increase in value more than the market (during periods of appreciation) or does it add a diversification benefit? An asset that adds diversification benefits would be expected to increase in value or simply not decrease as much as the overall portfolio when other assets in the portfolio are under stress.  The optimal position, from a diversification standpoint, would be when that asset doesn’t have a negative expected return when the rest of the portfolio is doing well.  In essence, a heads I win, tails I don’t lose much proposition. We are always on the hunt for such opportunities. Today, energy companies are an example of this unique setup.

Economic activity at its core is energy transformed. This is a topic our friends at Gavekal have discussed frequently. They point out that in most circumstances, deep bear markets in the S&P 500 have occurred while oil prices were strong, at least initially, in the face of economic weakness. The chart below displays the relative performance  during the DotCom crash for the S&P500, the Energy Sector ETF (XLE), and the Nasdaq. As you can see, energy stocks vastly outperformed both the Nasdaq and the S&P 500 index.

Books were written and movies made about the 2008 Great Financial Crisis. Most people know the housing market collapse was the main culprit, however not many realize oil prices were one of the initial reasons for the selloff in 2007 and 2008. The global economy was still growing in early 2008 but OPEC was out of spare capacity, so oil prices kept rising, eventually peaking at $140 per barrel on June 30^th, 2008. The economic contraction was exacerbated by higher oil prices and likely pushed equity markets even lower than they would have otherwise gone. By having a meaningful overweight to the energy sector, an investor would have had an effective hedge for the weakness in equity prices during most of the severe drawdowns. While oil eventually peaked and declined sharply and oil related stocks also declined with it, there was an opportunity to rebalance into stocks at lower prices, which is the aim when holding a hedge.

When oil prices decline at the first sign of trouble, lower oil prices result in lower costs for the economy and any economic slowdown will tend to be shallower than it would have been otherwise. Due to this one unique relationship, energy companies can serve as important hedges to a portfolio. When oil prices are stable in the face of weakness, energy companies benefit. When energy prices rise due to insufficient supply, the economy suffers, while the energy sector benefits. In the past, the energy sector comprised a more meaningful portion of the S&P 500, therefore providing a natural cushion to the market from this scenario. For reference, in 1995 the energy sector was 12% of the S&P 500 index, in 2005 it was 10%, and in 2015 it was 6.5% of the index. However, due to the extraordinary rise in technology-related stocks, today the energy sector is only around 4% of the S&P 500 index. In the scenario where we face stubborn oil prices in the face of economic softness, there is a high chance the overall market will decline even more, especially in relation to the energy sector. Therefore, in the long term, it makes sense to always hold meaningful exposure to oil prices in the portfolio as it can be a hedge for a unique but impactful circumstance. This outlines the strategic case for oil and why we believe we’re in a period when having oil and energy companies makes sense as a constant feature within a portfolio.

Now, let’s explore the current condition of stocks within the energy sector. In the past, oil and exploration companies were notorious for carelessly deploying capital at the worst possible time. However, in recent years there has been a lack of investment appetite due to expectations for oil demand declining as a result of an expected swift transition to electric vehicles. Lack of interest from outside investors has led energy companies to focus on balance sheet strength and resiliency.   Also, energy companies have developed more efficient drilling techniques that are more economical, more productive and more environmentally friendly. In the case of production and exploration companies, when we focus on the companies with the lowest cost of production, we are left with enterprises that are profitable, have embedded resiliency due to low levels of debt but also tend to return capital to shareholders through dividends and share buybacks.

When adding individual securities to the portfolio it is always our aim to select companies with strong balance sheets that can withstand a storm, even if we don’t always know which direction the storm will come from. Being able to combine resiliency, profitability and unique diversification benefits is an opportunity worth taking. Free cash flow yield is one profitability metric we pay close attention to. It indicates how much cashflow the company generates and is left over after the company covers its primary outlays from operations and capital expenditures. It is money available to the company that could be used to return capital to shareholders through dividends and share buybacks, or for investing in new projects. Today, the free cash flow of the energy sector is far higher than that of the S&P 500, indicating profitability and the capacity of the sector to continue paying consistent dividends or invest in new infrastructure.

One large hesitation from investors regarding oil and energy companies has been the expectation that fast adoption of electric vehicles and renewable energy for electricity production would lead to a sharp decline in oil demand. However, that hasn’t happened. Overall global energy demand keeps growing and although renewable energy supply is also growing and new, more efficient technologies are being developed, oil demand has yet to decline. Electric vehicles aren’t replacing combustion engine vehicles at the rate previously expected. In fact, hybrid electric vehicles are now emerging as a superior technology to electric vehicles. They are more efficient and more versatile than electric vehicles. But vehicles are not the only source of energy demand around the world. As emerging markets with large populations are developing into more robust economies, their energy needs continue to grow for all types of uses. According to OPEC, global primary energy demand is projected to increase by roughly 23%- 24% between 2022/2023 and 2045/2050. Utilities, vehicles, airplanes, and goods transportation all need energy and fossil fuels continue to be a significant portion of the mix. Peak demand for oil is expected between 2030 and 2034 but estimates of that timing keep being pushed back. On the other hand, oil supply is expected to start facing challenges, soon.

Below is a chart by the International Energy Agency depicting global oil demand projections.

At the same time, as illustrated, again by the International Energy Agency global oil supply is expected to face challenges far sooner.

Crude oil inventories around the world are also currently at very low levels, which is a reason to be constructive on oil prices in the short term.

               Adding a position to the portfolio requires us to look at the proposition from different angles. Oil and energy related stocks currently offer a unique opportunity to add strategic long-term diversification benefits to the portfolio through a corner of the market that makes sense in the short and medium term, as well. Combining different assets that have a unique upside proposition in specific scenarios adds to the resiliency of the overall portfolio and is how we aim to improve risk adjusted returns over time.