It’s hard to read the headlines of the past several years and not come to the conclusion that the world, or at the very least the United States, is awash in oil.

In fact, the Energy Information Administration announced last week that oil inventories in the United States are approaching an all-time high. Meanwhile, last year, thanks to shale drilling, U.S. crude production rose to the highest level in a quarter century. The United States is set to overtake Saudi Arabia as the world’s largest producer of energy.

By most fundamental measures, oil prices should be declining. So why is Brent Crude at nearly $110 a barrel, close to multi-year highs?

As I write in my new weekly commentary, there are a couple reasons that, despite the surge in domestic production, oil prices have reverted back to the upper-end of a multi-year trading range:

  1. Ukraine. Most recently, oil traders have become increasingly nervous over events in Ukraine. While equity investors have largely shrugged off the crisis, oil traders are reasonably concerned that escalating violence could lead to a series of tit-for-tat sanctions that could impact Russian oil production or, at the very least, exports.
  2. Falling non-U.S. production. Not all the factors pushing up oil prices are recent. Beyond the events in Russia and Ukraine, oil prices are elevated partly due to falling production throughout much of the Middle-East and Africa. For several years now, production has been falling in Libya, Nigeria and South Sudan, mostly due to terrorism and political instability.

Libya is a good example. Production quickly surged to 1.7 million barrels per day in the aftermath of the overthrow of Muammar Gaddafi. But thanks to more recent continued unrest, production has since slipped back to barely 250,000. As oil is a global market, reduced supply in Africa and the Middle East has been offsetting some of the surge in U.S. production.

The elevation in oil prices is one factor that has helped energy stocks outperform in 2014. Year-to-date, U.S. energy stocks are up more than 4% as measured by the S&P 500 Energy Sector, versus a gain of roughly 1% for the broader market as represented by the S&P 500.

So what does this mean for investors? For some time, I have been advocating an overweight to this sector, and I continue to stand by that position. The sector provides an important feature today: a potential hedge against rising geopolitical risk. Should events in Ukraine continue to deteriorate and lead to an escalating series of sanctions and higher oil prices, I believe energy stocks are likely to continue to outperform the broader market. I expect tensions to remain high and the issue to linger, although an outright invasion of Ukraine by Russia remains less likely.

Beyond the potential for increased turmoil in Ukraine, there are a number of other reasons many investors may want to consider sticking with an overweight to energy stocks. Most importantly, the energy sector is arguably one of the few bargains left in the stock market. The U.S. energy sector trades at 1.9x book value, a significant discount to the broader market and the sector’s own history. On a global basis, the sector is even cheaper, with an average price-to-book ratio of around 1.5.

Beyond value, we believe cyclical stocks like energy should benefit the most from an improving global economy. In addition, the global sector provides a healthy dividend of around 3% as measured by the iShares Global Energy fund (IXC) based off of the S&P Global Energy Index

Finally, while I don’t expect any inflation this year or probably next, should prices ever start to accelerate, energy stocks have historically provided a good hedge against inflation and a loss in purchasing power.

Sources: Bloomberg, BlackRock research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.

Funds that concentrate investments in a single sector will be more susceptible to factors affecting that sector and more volatile than funds that invest in many different sectors.

Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

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