How to survive an oil shock
The turmoil in the Middle East has raised fears of everything from war to nightmarish inflation. Some fear it will bring the world's economic recovery to a grinding halt. That in turn could drag down the value of stock markets and bonds.
The first question investors need to ask is: how long will the turmoil last? The obvious answer is that no one really knows. This is largely because no one knows how far or wide this will spread.
The worst-case scenario, from an oil-supply point of view, is if the turmoil spreads to the world's biggest producer of oil: Saudi Arabia. At this point, there have been few signs of a widening of the political crisis to Saudi Arabia. Indeed, Saudi Arabia is the oil market's saviour - its spare capacity alone is more than 2.2 times greater than Libya's overall daily production rate. And, it has repeatedly promised to increase output levels to provide protection to oil prices.
But what investors really need to be protecting themselves against is a worst-case scenario. And there are primarily two broad ways of doing that.
One, own the black stuff. Most of us do not live in bunkers in the Montana wilderness, and thus cannot store oil on our property. Nor is it easy or recommended for retail investors to play the oil futures market. However, energy and commodity funds, including ETFs, allow retail investors to get exposure to the physical asset of oil.
In choosing an oil fund, investors should: 1) check the performance history against other such funds; and 2) compare fees and avoid any fund with a gouging fee; an ETF in particular should have a cheap fee.
Below is a list of equity funds compiled by Thomson Reuters Lipper that invest in the oil industry. These funds have varying portfolio allocations and invest in different segments of the oil industry. As opposed to oil equity funds, commodities funds registered for sale in Hong Kong invest predominantly in metals and agricultural products.
The second way of guarding against even higher oil prices is to own oil companies. This gets a little tricky because a number of the big oil companies have operations in the Middle East, and thus may suffer some losses even as the price of oil is rising. Shell for instance produces in Oman, Occidental Energy in Bahrain, and ConocoPhilips in Libya.
The good news is that Chinese oil companies have less exposure to the Middle East than the Western oil giants. And investors can buy these shares on the Hong Kong stock exchange with a mere phone call or click of the mouse.
CLSA recently raised its target price for PetroChina shares to HK$14.3 from HK$10.68. It closed at HK$10.86 on Friday. The brokerage also has a 'buy' on Sinopec, with an HK$8.1 price target.
But although Sinopec is a major refiner and gas station operator, rising oil prices could be a double-edged sword for the company as its input costs are rising along with the price of its products.
Beyond the issue of protecting against (or profiting from) a jump in oil, investors might want to consider the broader effect of high energy prices on other asset prices, and on their portfolios.
Asian stock markets, for example, are more sensitive to oil prices because of the more energy-intensive nature of their economies (lots of manufacturing and lots of basic infrastructure development still taking place).
Bank of America Merrill Lynch strategist Sadiq Currimbhoy found that when long-term oil future contracts are below US$95 a barrel, it is good for Asian equities (as represented by the MSCI Asia Pacific ex-Japan index). However when oil futures start to go beyond this point, the correlation turns negative, with stocks falling as the oil contract price rises. Right now, the long-term oil future contract is at more than US$100 a barrel.
'Korea and Indonesia would start to suffer if global oil prices average US$100-120 this year. Net oil importers, including China and the rest of Asia, would be hurt if oil prices break the US$120 level,' Currimbhoy wrote in a recent research note.
However, in an odd way, there is a long-term reason why the turmoil in Middle East will be good for Chinese shares, at least compared with other emerging markets. And the reason is that the country's leaders will not put up with the same kind of guff that other states are now experiencing as their populations reel from the price of rising fuel and food. As a result, China is less likely to make the sort of short-term political cave-ins that cause long-term economic damage.
India, for instance, last year warned its citizens that it would lower fuel subsidies to 32 billion rupees from 160 billion rupees. Instead it ended up doubling them to 386 billion rupees.
If oil prices continue to rise, India is likely to be forced to throw more money at the problem - which will widen its fiscal deficit and could lead to investor flight. As JPMorgan analysts pointed out after India's budget proposal last week: 'If crude oil prices go higher, the finance minister will have to either deregulate diesel prices or live with a much higher fiscal deficit.'
This is where China's advantage comes to the fore. China is not a democracy. That does not mean the government does not face pressure to perform, but it does mean that the leadership can find it easier to make hard choices that will be better for everyone in the long term.
And one hard-core choice was made just recently - when Beijing raised oil and gas prices in line with the rise in global prices. It did this knowing it would contribute to consumer price inflation at a difficult time - with soaring food prices and higher prices for rents and manufactured goods.
Indeed, China is in the midst of a very tough clampdown in the fight against inflation - with the noose tightening around property speculators even as the central bank raises the cost of money, and limits the amount of new loans.
What this means in the long run, when the oil price storm is over, is that China will most likely emerge in better shape than other developing markets. Thus any strong dips in stock prices in the months ahead might be a good long-term buying opportunity.
The most well-known correlation to strong oil prices is the US dollar, which falls as commodities get stronger. Anyone with large savings in US dollars might consider diversifying a bit.
And because Hong Kong is pegged to the US dollar, the Hong Kong dollar will also get weaker, which is the last thing Hong Kong needs, when it is battling inflation. This is because a weak HK dollar attracts inflows into the property and stock market. So another consequence of strong oil prices could very well be more speculative pressure on Hong Kong assets.
