Oil price jump benefits investors for now, but potential for crises abounds

Mar 13, 2011 @ 12:01 am

By Arleen Jacobius

Institutional investors are seeing short-term gains from their recent commodities investments, but those gains could be overshadowed by an economic catastrophe if political turmoil overseas causes a drop in demand or an oil price spike to more than $200 a barrel, investment experts said.

And there is a lot that could spark a drop in commodities values — a protracted civil war in Libya, spreading democracy movements in the Third World, civil unrest in China and Pakistan, or a shaky financial system in Europe.

For now, the soaring price of oil spurred by unrest in Libya has helped institutional investors that bumped up their commodities allocation, notably in energy, see early positive results.

The Dow Jones UBS Commodity Index closed at 168.45 last Monday, up 25.8% from 133.94 on March 4, 2010. The index was up 3.73% year-to-date.

Investors have increased their investments in all types of real assets, including commodities and energy-related investments. Commodity investments, for example, grew 97% in the 12-month period ended Sept. 30 to $18.3 billion, while energy investments increased 188% to $5.7 billion, according to sister publication Pensions & Investments.

INSTITUTIONAL INFLOWS

Overall, institutional investors poured $8 billion into commodities in December alone, according to a recent Barclays Capital report. The study estimated that net institutional inflows of almost $46 billion will flow into commodities this year, amounting to three-quarters of the total inflows of $376 billion in institutional inflows for the year.

“Commodities have had a fantastic year in 2010, in that if you bought commodities in 2009 and held to 2010, in a lot of categories, you are above 100%” — with some returns more than doubling, said Scott Minerd, chief investment officer in the investment management firm Guggenheim Partners LLC.

But a rapid increase in oil prices to above $200 a barrel or a global political crisis could cause a worldwide disruption in demand for goods and services.

“Even though the cyclical outlook has surprised many to the upside, there are multiple potential "jump risks' that could quickly short-circuit the post-crisis recovery — particularly in the geopolitical sphere, said Nathan Sandler, co-founder and managing partner of ICE Canyon LLC, an emerging-markets investment firm. “If oil is priced at over $100 a barrel because the global economy is firing on all cylinders, there would be no story.”

Instability in Pakistan isn't a distant possibility, Mr. Sandler said.

“There are markers showing a government in Pakistan that is barely in control,” he said.

The problems aren't exclusive to the Third World. The European financial system is very weak and vulnerable, held together with heavy intervention and support from the European Central Bank, Mr. Sandler said.

Austerity programs in European countries such as Greece, Ireland and Portugal could lead to a backlash among their citizens and a potential for social instability, he said.

What's more, nobody knows whether the pro-democracy movements in the Middle East will spread. China, Cuba, North Korea and Venezuela could possibly be vulnerable, creating “contagion risk,” Mr. Sandler said.

“Widening political instability that disrupts the oil supply, destroys production or closes strategic transport routes ... would create a different kind of jump risk for the global economy,” he said.

Still, for now, governments' fiscal and monetary stimulus packages have produced higher returns, Mr. Sandler said.

Many countries are already employing all the fiscal and economic measures available to right the ships rocked by the 2008 recession, he said. This leaves them nothing else to pull out of their hats in another meltdown.

Newer investment sectors such as alternative energy could gain from disruptions in global oil production, said Michael Stark, founder and general partner of alternative-investment firm Crosslink Capital.

“We have choices now other than oil that we did not have before,” such as natural gas and plug-in hybrids, he said. “We think those choices will flourish.”

Social unrest could cause the governments of oil-reliant nations around the world to look at energy self-sufficiency, causing them to create subsidies, Mr. Stark said.

Larry Thrall, managing director of Vireo Energy, a clean-technology financial consulting firm, agrees that the “big winners will be renewable energy and natural gas.”

“I think we will see a big push for energy independence,” he said.

ALTERNATIVE ENERGY

Italy, which gets a big portion of its oil from Libya, already has taken a step toward converting to solar energy with a feed-in tariff program. Vireo Energy is helping Solar Investment Group, an energy developer, raise its second and third funds that take advantage of Italy's solar subsidy program, Mr. Thrall said.

Most investment analysts are watching to see if the pro-democracy uprisings continue to spread.

“Our position all along is that Saudi Arabia [and Kuwait] are the line in the sand,” said Alec Young, an international equity strategist at Standard & Poor's. “The reason we are feeling sanguine is that Saudi Arabia and Kuwait are wealthier than countries like Egypt.”

Kuwait and Saudi Arabia have been taking countermeasures, such as giving workers pay increases and interest-free loans, to avoid civil unrest, Mr. Young said.

“[A price of] $100 a barrel for oil is not a big deal to the economy. If the unrest spreads to the Gulf States, oil prices could spike to $200 ... That would be a game-changing type of event,” Mr. Young said.

Institutional investors in alternatives are also concerned that higher oil prices would hurt economic growth, thus damaging the value of private-equity companies.

So far, alternative-investment consultants haven't seen a reactionary boost to commodities or energy investments resulting from the turmoil overseas.

“I haven't seen any action based on that on the private-equity side.” said Mario L. Giannini, chief executive of alternative-investment consulting at fund-of-funds investment manager Hamilton Lane LLC.

HIGH VOLATILITY

Investors' reaction would depend on the type of institution and the risks that plan officials consider the most detrimental, said Matt Stroud, director and head of strategy and portfolio construction at Towers Watson & Co. Between natural disasters such as floods in Pakistan and Australia, and droughts in Argentina and Russia, “it's been kind of a perfect storm” leading to a lot of volatility in equity and commodities prices.

Executives of defined-contribution and public-defined-benefit plans are more concerned with inflation and have been adding real asset investments such as commodities, real estate and inflation-linked bonds, Mr. Stroud said.

Corporate pension plans, however, are more concerned with deflation than inflation and haven't added real assets, instead investing in long-term, high-quality debt in the same currency as the plans' liabilities.

Market watchers recommend a number of defensive measures to help fend off potential catastrophes.

“Gold and Treasury bonds are a way to hedge these risks,” Mr. Young said.

“Investors need to invest in gold more, but it has to be a real, man-sized allocation, not a wimpy allocation. You have to have 5% to 10% allocations to be a hedge,” Mr. Young said.

When there is turmoil in the world, there is a flight to quality, he said.

Not many institutional investors want to invest that much in gold — or can, Mr. Young said.

“The bull market in precious metals and money substitutes is very real and permanent. I believe oil is in a long-term bull market, but its increase is short-term unless there is a major revolution,” he said.

“With the recent run-up in gold, it appears a little pricey near-term. But generational bull markets last 20 to 30 years and we are in year 10,” Mr. Minerd said. “I personally think we will see $5,000 an ounce for gold, but not overnight.”

Mr. Minerd said he likes “things people aren't talking about. Industrial metals such as nickel look cheap, while copper could go higher, but it's clearly in a parabolic blowoff. Commodities such as wheat, corn, cotton and industrial metals, especially copper, are in the speculative category.”

Arleen Jacobius is a reporter with sister publication Pensions & Investments.

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