Oil as a Portfolio Instrument

Read the market analysis and fund positioning

Why Oil, Why Now?

The fate of the global economy is currently being decided along a 34-kilometre-wide waterway. What started as a military operation targeting Iran has, within weeks, triggered an energy crisis worse than that caused by Russia's invasion of Ukraine.

By effectively closing the Strait of Hormuz, Iran has cut off the most vital artery of the energy market. Shipping traffic through the strait has plummeted by over 90 per cent. The bottleneck has become a dead end. The issue is no longer a shortage of crude oil, but rather the inability to transport it. Saudi Arabia has suspended production at its largest refinery as a precautionary measure. OPEC+ has announced an increase in production for April, but new barrels will be of little use if they cannot leave the Gulf.

The price reaction was correspondingly dramatic: Brent rose from around USD 66/barrel on a 2025 annual average to a peak above USD 112, before stabilizing around the USD 100 mark. The base-case scenarios of Wall Street analysts point to an average price of approximately USD 100 for the coming months. But the risks are asymmetrically distributed: J.P. Morgan estimates that reassuring headlines could push the price down by around $10, whereas further production cutbacks in the Gulf could push it up by around $30.

For a multi-asset portfolio manager, an important question arises: can they afford to exclude oil price dynamics from the equation?

Oil and Inflation: The Transmission Channel

Oil has the most immediate impact on investment portfolios through its effect on inflation. On this point, forecasts from major investment firms are remarkably consistent: a sustained 10% increase in the oil price raises US headline inflation by around 20–35 basis points, while core inflation rises by only 3–4 basis points. The effect on headline inflation lasts for around three months and then fades away, provided that the price surge remains temporary. For the eurozone, the sensitivity is even more pronounced. Morgan Stanley estimates that a USD 10 increase in the oil price per barrel would raise HICP inflation by around 40 basis points, and a sustained USD 80 level would increase it by as much as 60 basis points – well above the ECB’s target of 2%.

Goldman Sachs has raised its forecast for US headline PCE inflation at the end of 2026 by 0.8 percentage points, bringing it to 2.9%. The core rate is currently 2.4%, which is 0.2 percentage points higher than before the conflict. Without the impact of tariffs and the oil shock, the core rate would be around 2.3%, which is close to the Fed’s target.

This highlights a tension that we first identified in September last year: while oil is pushing prices up in the short term, artificial intelligence is having a long-term deflationary effect. We view AI as a 'perpetual machine' of price dampening – a highly efficient factor that central bank models have barely captured so far. This thesis remains unchanged. The oil price shock is the strongest cyclical counterforce to this structural trend. It temporarily overshadows the AI disinflation dividend without cancelling it out. Portfolio managers now face the challenge of separating the cyclical wave of oil-driven inflation from the structural deflationary force of technology, and aligning their allocation accordingly.

Oil and Central Banks: The Return of Rate Hikes

Oil price shocks present central banks with a dangerous dilemma: rising prices coincide with falling growth. While the ECB was signalling interest rate cuts as recently as January, the threat of inflation exceeding 3% is forcing a radical U-turn. Some institutions are already anticipating further interest rate hikes – a scenario that was unthinkable just a few weeks ago.

The US is more resilient thanks to shale oil. Yet, paradoxically, at a certain point, oil has a 'dovish' effect here: prices become so effective at destroying demand that they trigger a recession, making it more likely that the Fed will cut rates.

The implication for duration is that, historically, yields on 10-year US Treasuries have risen by an average of 60 basis points following oil shocks, as the impact of increased energy costs has fed through only gradually. This makes long duration risky until a decisive turning point is reached.

However, if market sentiment shifts towards a collapse in demand, duration suddenly becomes attractive in an asymmetric way. Bonds then protect the portfolio, whether oil prices fall or the economy stalls.

With moderate price rises, duration should be shortened, whereas at extreme levels it becomes a hedge. Portfolio managers today must therefore know which regime they are in.

Oil and Equities: Sector Rotation and Natural Hedging

The stock market does not react to oil shocks as one entity, but along deep sectoral divides. While energy and defence stocks are booming, airlines, car manufacturers and banks are under pressure. The key factor is what causes the price surge: if oil prices rise due to a growing global economy, share prices tend to rise too. However, in the event of a supply shock, such as in the Strait of Hormuz, the correlation turns negative. In this scenario, exposure to energy is not a speculative investment, but a necessary hedge.

The structural risk lies in the sector's declining relevance. Energy producers currently account for only 3% of US market capitalisation, compared to 30% in 1980. Consequently, the broader market has lost its natural hedge against energy costs. Anyone investing passively in the S&P 500 today is effectively holding an implicit short position in oil without receiving a premium for it. A targeted allocation of energy shares and gold can significantly reduce drawdowns during periods of market turmoil without affecting long-term returns. While electrification remains an issue for the future, today’s risk is the blockade in the Gulf.

Oil and Currencies: The Petrodollar Feedback Loop

The fact that oil is traded in dollars has consequences. Barclays estimates that a 10% increase in oil prices would strengthen the US dollar by up to 1%. The logic is compelling: rising energy costs boost demand for the dollar, while the currency simultaneously benefits from its safe-haven status. This creates tactical tension with our scepticism about the USD, which we have held since April 2025. In the short term, the oil shock is supporting the dollar. In the medium term, however, overvaluation and the high current account deficit continue to weigh against it. We are therefore maintaining a neutral stance on the USD.

Particular attention should be given to the Japanese yen. As a major energy importer, Japan is highly vulnerable; for example, a 20% rise in oil prices would reduce real GDP growth by 0.12 percentage points. This dilemma of fighting inflation versus supporting growth is presented to the Bank of Japan. For our JPY position, which was established in February, this means short-term headwinds, even though the thesis of structural undervaluation remains intact. For the euro, meanwhile, energy dependence is worsening the terms of trade and putting pressure on the exchange rate, which is acting as a structural drag on our EUR bond allocation. However, this is still being cushioned by the current carry.

Synthesis: Oil Within ETHENEA's Risk Management Framework

In November, we organised our risk management into eight categories, at least four of which are affected by oil: market risk, inflation risk, currency risk and concentration risk. Oil is not just an isolated commodity issue, but a cross-cutting factor that influences duration, credit quality, sector mix and currencies simultaneously. While a portfolio manager does not need to trade oil, they must be aware of the implicit oil price assumptions underlying their allocation.

Duration: In the early stages of an oil shock, the long-term risk profile is negative – breakevens widen and nominal yields gradually rise. However, when prices reach extreme levels that trigger a collapse in demand, the dynamics reverse.

Credit quality: Spread asymmetry across the market as a whole – tightening on good news and widening amid growth concerns – argues in favour of a defensive stance during oil shock phases.

Equity exposure: A selective allocation to energy and commodities can act as a hedge against supply-driven oil price shocks. It is crucial to distinguish between supply and demand shocks in this context.

Currencies: The dollar tends to strengthen when oil prices rise, putting pressure on the currencies of major energy importers.

The Iran conflict in March 2026 painfully exposed these dependencies. However, even if a settlement is reached, the underlying structure will remain in place for as long as the global economy is dependent on fossil fuels, oil is invoiced in dollars, and production remains concentrated in unstable regions. Consequently, crude oil will continue to pose a significant cross-cutting risk.

Settlement ultimately takes place in dollars. However, as not only this March but also the entire post-war history teaches us, the decision is made on the oil markets.