Oil price high, stock markets low

Andrew Vaughan - Wed 31 Aug, 2005

...There is something strange happening in global markets. The oil price is scaling new heights, yet stock markets are too. How can the soaring cost of energy be anything other than negative to the global economy?...

Oil price high, stock markets low

There is something strange happening in global markets. The oil price is scaling new heights, yet stock markets are too. How can the soaring cost of energy be anything other than negative to the global economy?

Affordable energy is central not just to corporate profitability, but to household "profitability" - our ability to consume or invest. It thus impacts the mobility of labour and the movement of traded goods.

So why the recent four-year highs hit by the FTSE, Dax and Japanese Nikkei? The answer is that, when the world's corporate landscape is dominated by oil corporations, a higher oil price combined with growing demand for oil is very good news.

ExxonMobil, BP, Royal Dutch Shell, Total - four out of the world's fifteen largest corporations all make their money from oil. And that's not including the state-owned oil businesses in many producer countries.

Microsoft, Citigroup, Bank of America, HSBC, Vodafone - many of the other top fifteen corporations have input costs almost totally unaffected by higher energy prices.

Oil price high, stock markets low: Impact on high oil prices

The positive impact of high oil prices on stock markets is further exaggerated by the dominance that oil corporations have over local equity indices. The capitalisation of BP, for example, is not spread over several stock markets, but distilled into London and the FTSE100 index. Add in a strengthening dollar - the currency in which oil is priced - and we have a potent force exerting itself on corporate earnings.

Or at least...in the short-term...

But look at some of the remaining companies in the global top fifteen - General Electric, Wal-Mart, Johnson & Johnson, and Pfizer - and we see businesses that are paying higher input prices already. There comes a point at which even banks and mobile telephony providers could be brought down by the burden of higher energy costs on the wider economy.

Your investment stance must meet this incongruity head-on. We've told Zurich Club members many times before, but there is a logic to holding investments that gain from an upward move in oil. Not only do they prosper in this environment. They also provide portfolio "insurance" against the unthinkable - an oil price shock that brings other investment values crashing down.

Oil price high, stock markets low: Oil supply shock

So far, an oil supply shock - as happened in the 1970s - is what we notably have not suffered. The oil price is riding high in the middle of summer, when demand is seasonally weaker, while oil is flowing unimpeded from the Middle East. Refining output may be hitting capacity constraints, but crude is being freely pumped and shipped from the so-called 'swing' producers who most closely affect global oil output.

Changing times in Saudi Arabia, however - the world's biggest exporter - should remind us how precarious our oil world is. The price is high even with this shock-free supply backdrop. It is simply the growing demand for crude - and from nascent major consumers such as India and China - that is driving prices higher. That demand is not going away, and the possibility of a supply shock remains ever present.  

We are also witnessing a land grab by China as it seeks to achieve security of oil supply. Rebuffed in its proposed $20 billion takeover of Unocal in the US, China National Overseas Oil Corporation is now set to turn its sights elsewhere. Takeovers too by Kinder Morgan (pipelines) and Valero (refining) are positioning these businesses to prosper from the increasing viability of "sour" crude from frontier locations in North America.

Which is why the Zurich Club portfolio now includes four oil-related plays, and our core UK holding - an investment trust - features BP and Royal Dutch Shell among its top-ten holdings. Our other diversified fund, an emerging markets play, has Petrochina as its second largest holding.

Oil price high, stock markets low: Investment instruments

For Daily Reckoning readers wanting to address both the threat and the opportunity that today's soaring oil price presents, I will now set out some guidelines to the myriad investment instruments that are available.

** Developed market oil majors such as BP (UK), Exxon (US), Total (France) are large, liquid and widely researched shares. Their correlation with the oil price is perhaps surprisingly low.

** Emerging market oil majors. With Russia being the principal oil emerging market, you may wish to look at Lukoil and Surgutneftegas. In addition to the usual equity risks, specific emerging market risks apply.

** High cost/frontier oil producers. With established oil reserves that are costly to extract - such as the Canadian Oil Sands - a sustained high oil price transforms their viability.

** Oil exploration. These businesses tend to have little intrinsic value, with stockmarket values based largely on expectations of future worth. As such, they can be extremely high risk investments. None feature in the Zurich Club portfolio.  

** Oil support services. These benefit from high activity and pricing levels in the oil exploration and production, but their relationship with the oil price is remote.

Aside from equity investment, there are also futures and spread bets you may consider to access the rising oil price. These offer direct correlation with the oil price, but they are short-term in nature and not "buy and hold" investments. Covered warrants, for instance, offer full upside with limited downside. With the exception of "certificates", these have a limited life. Note that some represent an energy-centric basket of commodities, rather than pure oil price exposure.

Exchange traded funds also give you exposure to the oil price. The recently listed Oil Securities ETF offers cost-effective and easily traded direct exposure to the Brent Crude price. Unlike futures, spread bets or covered warrants - with their finite lives - an ETF can be held indefinitely.

In short, I believe oil exposure offers further upside potential for UK investors, uniquely combined with wider portfolio "insurance" against a real oil shock. Indeed, I regard it as a "must have" for all portfolios.


Regards,

Andrew Vaughan
for The Daily Reckoning