With turmoil in the Middle East dominating headlines, many investors are wondering what the recent and growing unrest in the region means for oil prices and for equity portfolios.

While I certainly can’t predict the outcome of events in the Middle East, oil prices are likely to remain toward the upper end of their recent range for the foreseeable future given current supply and demand dynamics. Even without a sustained spike in oil prices, there’s a strong case for sticking with energy stocks simply based on valuations.

First, here’s a quick look at my expectations for oil supply and demand. Currently, oil prices remain elevated because global demand has continued to climb, despite slower growth in China, and supply overall has been unexpectedly constrained by both geology and geopolitical unrest. Looking forward, oil supply is likely to remain constrained and oil demand is likely to continue to grow.

Oil supply: There’s a good chance that future oil supply may be tighter than expected. Currently, oil prices remain in a somewhat precarious balance, supported by a long-term rise in North American production, but at the mercy of falling production and exports in much of the Middle East and Africa.

However, U.S. production growth is likely to decelerate in the coming years, placing more of a burden on OPEC, where rising geopolitical risks put supply increases in jeopardy. In other words, at a time when stable North American production will be decelerating, there will be an increasing call on production from the most unstable parts of the world, particularly Iraq. This in no way suggests that the world is somehow “running out of oil,” but it does mean that given the low likelihood of a clear resolution in the Middle East, supply is likely to disappoint.

Oil demand: Meanwhile, oil demand is likely to continue to rise. Over the long run, economic activities and population growth are the key drivers of oil demand. While oil demand in developed markets is likely to remain soft on the back of improving efficiency and slower secular growth, increased demand in emerging markets — driven by urbanization and increasing car ownership — will probably offset this trend.

As for what this means for investors, even without the prospect for higher oil prices, I would maintain an overweight exposure to energy stocks simply based on valuations. Despite outperforming year-to-date, energy sector valuations still have room to grow, as measured by looking at the S&P Global 1200 Energy index. Multiples are still at a discount to their 10-year average and fund positioning is low, as I point out in my new Market Perspectives paper. In addition, I continue to see good free cash flow and several recent investment projects are beginning to bear fruit.

Source: Market Perspectives piece “Oil’s Precarious Balance

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

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