By Alexander Jolliffe –
Crude oil prices have surged to record highs in cash terms in recent weeks, throwing a spotlight on commodities, an asset class that many private investors have neglected in spite of its record of beating inflation.
The oil price has come close to $50 (£28) a barrel, double its level in nominal terms a little over two years ago, as strong demand from emerging economies including China has taken effect. Michael Lewis, head of commodities research at Deutsche Bank, says: “China has really surprised on the upside.”
While other economists note that oil prices are lower in real terms than during the 1970s, the crude increase is accompanied by the disclosure this week from the Organisation of Petroleum Exporting Countries that its members drilled 6.5 per cent fewer wells in 2003. Analysts said this suggested the global supply crunch and high prices could last longer than expected.
The price increases underline the attraction of commodities, which have also performed well over longer periods. Goldman Sachs says its commodities index has generated annualised returns of 12.6 per cent since 1970, beating the Standard & Poor’s 500 index of US equities, on 11 per cent.
In spite of such advantages, private investors have struggled to gain exposure to commodities. Market participants say it is difficult for individuals to trade commodity derivatives, so funds would be a better bet. Until recently, they were hard to come by.
However, Barclays Global Investors last month launched a commodity fund that will have about 70 per cent of assets in energy and will aim to match the returns of the Goldman Sachs index. While the fund is aimed primarily at institutions, high net worth investors are also welcome.
Commodities diversify portfolios, often rising when share prices fall, and have beaten inflation over ten-year periods.
Research by economists at Barclays Capital in the Equity Gilt Study of investment returns shows that to get consistent positive real returns from equities, investors at times had to wait at least 20 years. By contrast, they waited only ten years to achieve inflation-beating returns from commodities as measured by the Goldman Sachs index.
So it took twice as long to get consistent real returns from equities as from commodities, which provide the best hedge against inflation during periods of unexpectedly sharp price rises.
Barclays Capital says commodity returns do not move in tandem with equities, so the two asset classes provide good diversification when combined in a portfolio.
Robert Lockie at Bloomsbury Financial Planning says: “If you have two volatile assets but they move in different directions, you’ll get a smooth return by combining them.”
The surge in the price of oil has been the result of strong demand, driven by growth in the US and the expansion of the Chinese economy. Deutsche Bank estimates that oil demand has gone up by 2.3m barrels a day this year, compared with a20-year average growth rate of1m-1.5m b/d.
Robust demand is expected to continue. The International Energy Agency expects China’s oil demand to surge by 14.5 per cent this year and to rise by a further eight per cent next year. It argues that attempts by Beijing to cool economic expansion are unlikely to have a big impact on demand. The IEA expects world oil demand to grow by 2.2 per cent in 2005, a minor slowdown compared with this year.
The nature of the demand is attractive because it is relatively insensitive to price. Consumers need to heat their homes and buy fuel for their cars, so even if the price of oil doubles, consumption does not change much. To investors, that is attractive. “You have a captive consumer,” says Jeffrey Currie, head of commodities research at Goldman Sachs, the investment bank.
Nor is the demand dominated by speculators, to judge by weekly data from the Commodity Futures Trading Commission. While speculative players are active, they do not overwhelm the market. Net speculative long positions in the US crude oil, heating oil and gasoline futures markets combined are only 60 per cent of the peak reached last March, when crude prices were $10 a barrel lower. Barclays Capital calculates that gross speculative long positions in crude oil are well below the current average level across 22 commodity markets.
As for the supply side, output outside the Organisation of Petroleum Exporting Countries is struggling to match the rise in demand. In Russia, an important source of expansion, the government has predicted slower oil export growth until 2007. Opec is running above 95 per cent of capacity.
Oil is not without risks, and financial advisers say investors should have only about five per cent of their portfolios in commodities, to limit exposure to the asset class’s dangers. Commentators warn that a sharp drop in oil prices after last week’s attempt to hit $50 a barrel cannot be ruled out.
While falling prices would not change the underlying tight supply and demand balance, a glance at commodities’ record shows that short-term investors can lose big sums. Although commodities have beaten equities since 1970, there have been bad years. In 1998, Goldman Sachs’ index fell by 36 per cent, hit by the Asian financial crisis. And in 2001, the September 11 attacks hit demand for jet fuel and the index dropped by 32 per cent.
Barclays Capital warns that over the short run, commodities do not always provide a strong hedge against inflation. Although they provided robust returns immediately after the 1970s oil price shock, the correlation with inflation was negative in the late 1970s.
Index-linked gilts provide investors with greater protection against inflation in the short run, says Barclays.
There is the danger that the foreign exchange markets move against you. Ben Yearsley at financial adviser Hargreaves Lansdown says: “Commodities are priced in dollars, so there is a currency risk.”
In spite of such risks, advisers say commodities are potentially attractive. Lockie at Bloomsbury says of Barclays Global Investors’ fund: “It gives investors exposure to the asset class, and it’s cheap.”
Source: Yahoo News
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