Here’s how investors should respond to skyrocketing energy prices

The answers to all of these questions are not simple. But by looking at the root causes we can get a better understanding of how these issues will develop and how investors should respond.

The short version

• Gas prices have been on the rise for a while. To understand why gas prices are so high, you need to realize that energy prices have been this high before.
• The simple reason for the rise in prices has to do with supply and demand. Coupled with changes to government policies and pressure from the public to focus on green energy, and add in a war with a major oil producer, and you have a formula for a dramatic rise in prices.
• For investors worried about the rise in energy prices, there are a number of safe-haven investments to consider instead, like gold and U.S. Treasuries.

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Why are gas prices so high?

There are a number of interlocking factors for why oil started 2021 at $50 a barrel, and currently stands at around $108 a barrel. But at the end of the day, oil, just like any commodity, is priced based on supply and demand.

While the sudden, nearly instantaneous lockdown of the world caused a huge reduction in demand, leading to negative oil prices for the first time in history as oil producers struggled to turn off their taps and find storage for all their barrels, the high prices we see now are closely related to the supply part of the equation.

Oil prices over the last 10 years

To fully understand how oil skyrocketed, we need to look back on the last decade.

As you can see in the chart above, while the price of oil in the last five or so years hovered around $60 a barrel, the prices of a decade ago were about where we stand now. This is important to keep in mind as the media bangs on about sky-high prices: Commodities are always cyclical, and we’ve been here before. What else is important to notice is that in 2014, prices collapsed by over 50%.

The price rise into the early 2010s came at the tail end of the Great Financial Crisis. Oil prices spiked on Chinese demand, and then crashed down to $30 a barrel as economies around the world slowed down. However, the price of oil would quickly rebounded due to the Arab Spring protests that erupted across the Middle East.

These uprisings spooked oil markets into worrying about supply shocks. And these fears became a reality when the Libyan civil war broke out in 2011, wiping out oil production. Iranian sanctions on oil imports further tightened the market.

Prices further dropped due to shale (fracking) technology. This new method of drilling for oil in previously impossible locations at a cheaper price led to the United States becoming the largest oil producer in 2018. The world markets quickly became overflowing with oil supply, leading to a steep decline in price.

A wave of bankruptcies hit the market in 2015 but many continued drilling as a means of survival. This all came to a head when the great pandemic shutdown of 2020 occurred.

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The impact of the pandemic on oil prices

Pre-Covid, global oil demand stood at 99.7 million barrels per day. But as the world shutdown, the demand was reduced by approximately over 20 million barrels, a 20% decline in demand within a month. Subsequently, oil prices collapsed from $45 to $20 a barrel, a price in which only legacy producers such as Saudi Aramco were even able to produce at a profit. Unsurprisingly, a serious wave of bankruptcies followed suite.

If that wasn’t enough, public demand for more serious ESG compliance in their investments led to banks significantly reducing their credit to oil and gas companies.

Many international oil companies began to publicly disavow investment in oil assets, with firms like BP rebranding itself as a green energy firm. All of these factors together significantly curtailed capital expenditure in the industry, which is normally required to maintain the same level of output.

Re-opening

Towards the tail end of 2021, countries began re-opening their economies en masse. This led to a big uptick in petrol demand, as people began driving and traveling more. The issue however was that by this point, all the built-up supply had largely been drawn, and oil companies weren’t drilling enough to keep up.

Multiple explanations have been given for why oil companies have continued to under-produce despite rising demand. Just recently, the Biden team in the White House claimed that their lack of production was all to do with greed. After all, the less they produce, the higher oil prices go and the more money they can make.

The true reason may be a bit more complicated. Waves of bankruptcies have lead to potential oil assets being dormant. And when President Biden took office, he froze all new oil and gas drilling permits on federal lands.

The final explanation for the lack of production has been that oil companies have become far more fiscally conservative and risk averse. Rather than taking their chances by drilling a new location, they would rather produce what they have and pay down debt. Or they would prefer to return capital to shareholders than draw fire for producing more.

All of these factors have combined to cause oils steady climb upwards. But Russia’s invasion of Ukraine really sent things into overdrive.

The Russia invasion of Ukraine

Russia produces approximately 10% of global oil annually, putting it in the top three producers worldwide, behind the U.S. and Saudi Arabia.  So if anything happens to Russia’s ability to produce, it has significant ramifications to practically every country around the globe.

That is exactly what happened when Western countries issued a range of sanctions on Russia, including the U.S. ban of Russian oil imports. The SWIFT ban on Russia also constrained its energy trade. And many oil shipping companies are outright refusing to pick up Russian oil, even at a discount, for fear of being caught in the crosshairs of additional sanctions.

That really sums up how oil has gone from a negative number, to the highest price in over a decade, all in a few short years. The negative price was the result of a completely unexpected demand shock. And today’s sky-high price is the result of a completely unexpected supply shock.

How should investors respond to the energy crisis?

What can investors do to protect their portfolios against these kinds of drastic price moves? There are a few options that investors can consider adding to their portfolios.

Invest in energy stocks

The best solution is sometimes the most straightforward. One option is to invest directly in energy companies. So far, this has been the most lucrative way to play the trend of higher oil prices. As energy prices rise, it increases the profits of oil companies. Of course, the energy space is highly varied, with highly levered companies as well as oil majors. If you want correlation to oil prices, avoid major oil companies like BP and Shell which are actively moving away from oil.

For those afraid of investing in such a volatile sector, there are ways to buy a diversified basked of these businesses such as ETFs.

More: How to invest in oil

Buy inflation-linked bonds

For investors wary of investing in such a cyclical industry that is guaranteed to go down just as it's gone up, one viable option to consider is TIPS, or the U.S. Treasuries inflation linked bonds. Many investors have ignored bonds due to over a decade of ultra low interest rates. This is even more true now that inflation is above the interest rate of all bonds.

However, TIPS skip over this bond weakness and turn it into a strength. Its payments are automatically adjusted to the inflation rate. This means investors get the protection of U.S. bonds in times of crises, along with inflation protection. A 10-year treasury currently yields around 2%. Compare that to the last CPI reading, which is one way the US government measures inflation, giving a reading of 7.5% annualized inflation. If you hold TIPS, your principle increases alongside inflation giving you a much more attractive return on your money.

More: Investing in Treasury bonds

Find businesses with a moat

During inflationary periods, Warren Buffett recommends looking for companies that have “economic moats.” Economic moats are unique market positions that allow businesses to raise prices without losing customers.

This is key during periods of high inflation as most everyone will be raising prices. In turn, many businesses will lose out on customers, while still having to deal with increased costs of goods sold. But businesses that have large gross margins that can absorb a decrease in profitability.

Consider buying precious metals

Finally, we have precious metals, which have been seen as an inflation hedge for thousands of years now. Why focus on inflation when we’re talking about energy prices? Because energy prices are directly correlated to inflation, as petrol makes up a comparatively large percentage of our spending. Generally, high energy prices can be a large factor in high inflation numbers.

The way to protect against inflation has traditionally been precious metals, of which gold has always been the most popular. While gold has risen less than other commodities in the last year or so, it does hold the additional benefit of being an asset that always rises during times of panic. We saw this during the onset of Russia’s invasion of Ukraine, which sent the price of the yellow metal soaring.

So if you are an investor worried about unforeseen shocks, or central bank mismanagement as well as consistently high energy prices, gold may be worth considering.

More: How to invest in gold

Are high energy prices here to stay?

The above is probably the third most important question that investors should ask themselves.  While I can’t give you exact date for when energy prices might come back down, one important thing to remember is energy is a commodity. And like all commodities, it's ultimately cyclical.

The old saying ‘the cure for high prices is high prices’ is especially true when it comes to oil. At a certain price, all of the reasons we gave for why oil producers aren’t producing more goes out the window. And drilling will commence left and right. And it’s likely that after the Russia-Ukraine conflict concludes, Russian oil will at some point come back to the market. Unfortunately, it’s impossible to know when this will happen.

All of this will eventually lead to oil prices coming down. And with the U.S. government more focused on green energy than ever before, we may even see it stay down indefinitely. But when these corrections will take place and what impact they'll have on broader inflation remain a mystery.