Proceed cautiously when chasing oil returns

Oil once again had a record day on Wednesday, topping $132 a barrel. Since energy prices generally eat into the margins of many other sectors, it’s tempting to continue to allocate a larger portion of the portfolio to energy sectors to function as an earnings hedge. If clients choose to do so, portfolio strategists suggest they proceed cautiously.

With shrinking new supplies of oil and increasing global demand, there are virtually no voices that are saying oil will drop to the low-levels of the early part of this decade. However, you can still have a long term bullish outlook on oil and believe it’s overpriced in the short-term.

This is the position taken by Richardson Partners Financial Limited’s Andy MacLean and Clancy T. Ethans.

MacLean, director of private client investing, and Ethans, senior vice-president and chief investment officer, note in their latest MarketPoint report that historically demand destruction for oil tends to start at anywhere between 1.5 and two times the marginal costs of the most expensive producer. The world’s highest cost production is in the Alberta oil sands where it can be as high as $70 per barrel. History would suggest demand begins to drop off in the $105 to $140 range.

In fact, MacLean and Ethans say demand is dropping even in China. However, the supply situation then is the reason for the rising prices. Supply is falling faster than demand.

“Usually with rising prices there’d be a supply response where the swing producer (Saudi Arabia) would begin to ramp up production to bring prices under control. Perhaps Saudi Arabia’s excess reserves are not as large as had been thought. Another supply problem is with Russia. The country with the world’s second largest reserves has overproduced its old wells, which are now beginning to grind down, while not developing new production,” MacLean and Ethans write. “Some of these supply issues could persist over the next several months but in an environment of falling demand the oil market looks increasingly vulnerable to a correction.”

Canadian investors are in a unique situation, in that oil prices play such a crucial role in the weighting of the Canadian equity index. If client are looking to rebalance their portfolios, they have to consider both their energy holdings and their Canadian equity holdings.

This is something Brent Smith, chief investment officer of Fiduciary Trust Company and lead manager of Franklin Templeton’s Quotential program, pointed out at a road show for advisors in Toronto late last week.

“The long-term secular outlook for the Canadian market is very positive. The Canadian stock market is much more concentrated than it’s ever been. Take a look at the TSX stock market in 2000 and 2001. Nortel was 35% of the index. Nortel rolls over, the market gets hammered,” Smith said. “If oil and gas goes from $125 to $80, it doesn’t matter if you have 50 companies in the Canadian oil and gas market, they are all going to go down, and it will have a huge negative impact on the Canadian stock market. You have to be aware of the concentration risk in the Canadian marketplace even though longer term we think is going to do quite well.”

MacLean suggests that investors try to keep their direct exposure to oil under 25% of the portfolio — an underweight position.

“We have taken an underweight position in energy-related stocks. When commodities begin to run, from a technical perspective, they tend to overshoot dramatically on the upside. That’s what we feel is going on with oil right now. We are recommending to clients not to chase the energy stocks,” MacLean says. “The price of oil right now at least from an intermediate term historical perspective is trading at the extreme upper-end of the range. That usually suggest we will see a pull-back. That’s not to say we would see a dramatic reversal of the trend. “

According to Dina Cover, an economist with TD Bank Financial Group, the price of oil is out of whack with the economic fundamentals.

“We are thinking the price is coming down simply because the high prices aren’t fundamentally supported. There are so many other factors driving these prices up, such as geopolitical tensions,” she says. Overall, by the end of the year we believe oil prices will be down around $100. That will affect all energy prices such as natural gas which feeds off of that.”

Clover can’t put her finger specifically on one or two factors that have led to the disparity between economic fundamentals and actual prices, but she suspects a slew of outlook prices released recently by investment banks has fueled speculation, which in turn has raised prices.

For instance, on Tuesday, Credit Suisse raised its forecast on oil prices for the following year to $110 from $90 and Societe Generale, raised its outlook by $14 a barrel to $115. Other investment houses, such as Goldman Sachs had previously raised their outlook to more than $140 a barrel.

“The markets right now are adequately supplied but investors are looking to the future. It’s the future prices that are high. Lately the price has been driven up because all of these investment houses and banks have been increasing their forecasts to $140 for the second half of 2008. That’s really driven up the price,” she says. “[Crude] supplies have been increasing, which should counter prices going up. OPEC has said some of their countries, Nigeria for example, had supply disruptions but Saudia Arabia increased production to make up for that.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(05/21/08)

Mark Noble