Here's a mystery for you. The price of oil has more than doubled over the past 15 months. It rose during the darkest days of the recession and Monday continued its seemingly inevitable climb to US$90 a barrel. But why? Despite a recovering global economy, oil consumption is growing only slowly. Inventories are generous. The futures market is signalling that supply will be ample during the next few years.
So why should the price of oil be surging? The most likely explanation is that oil is no longer simply that stuff that fuels our cars and heats our homes. It's become a financial asset. And that has implications, not only for energy investors, but for the loonie as well. Oil's new status as a financial asset shows how large institutions -- pension plans, university endowments and sovereign wealth funds -- are tinkering with their investment strategies. These huge investors have come around to the notion that they should keep 5% to 10% of their money in commodities as a hedge against inflation and as a counterweight to the stock market.
You can condemn this strategy as speculation -- rest assured that some U.S. Congressmen will seize the opportunity in the months ahead to do just that -- but the reality is a bit more humdrum. Large investors aren't whooping it up at a casino, trying to cheat the poor consumer. Rather, they're engaged in the entirely respectable task of trying to buy assets that offset their risks in other areas. For instance, one major motivation for institutional investors to stock up on oil is fear that the U.S. dollar is set for a long decline. In contrast to the greenback, oil is a truly liquid currency -- one that the Fed can't inflate away. Can you blame investors for stocking up on a bit of inflation repellent?
The size of investors' appetite for oil as a financial asset became clear last year, when crude prices rocketed from a low of US$33 a barrel to above US$80, despite swelling inventories and mediocre demand from end users. Investors continue to drive the market for oil, pushing prices above US$86 a barrel Monday -- and this despite the opinion of no less an expert than King Abdullah of Saudi Arabia, who has said a couple of times over the past two years that US$75 to US$80 a barrel would do just fine, thank you. As long as investors' enthusiasm for oil lasts, we live in a surreal world in which the fundamentals of supply and demand seem to have lost their traction.
If consumers' appetite for energy were the deciding factor, it's hard to see what would be forcing oil prices higher. The International Energy Agency predicts a less than thrilling 1.8% increase in global demand this year. Supply seems ample, as well. Oil inventories in the United States are at above-average levels, and the futures market is quite happy to guarantee you delivery of oil in 2014 for only about three dollars more than it would cost you to buy a barrel today. But neither slow-growing demand nor the market's expectation of ample supply for years down the road has been capable of shaking investors' enthusiasm for oil as an asset class. "This raises a key question," says Bassam Fattouh of Oxford University in a recent paper on oil pricing. "If market participants attach little weight to current market fundamentals and if future market fundamentals are highly uncertain, at which price or price range should the oil market clear?"
His answer is that oil prices have become "indeterminate" -- a professor's way of throwing up his hands and saying you can no longer predict what's going to happen next. Oil's price depends upon a guessing game among major market players in which everybody is trying to guess what prices other players are guessing. If that is correct, oil investors can expect some neck-wrenching swoops in the years ahead as bulls and bears take turns in the pilot's seat. Your best compass to what lies ahead for oil prices may not be what's happening at the gas pump, but how the S&P 500 is faring. John Kemp, a Reuters columnist, recently looked at the link between U.S. oil inventories and the price of oil during recent years and failed to find any consistent relationship. What has reliably moved oil prices? The stock market. When stocks have gone up, so has oil, and vice versa. "It is one more piece of evidence [that] crude oil prices ... are trading more like financial assets than raw materials," Kemp concludes.
For Canadian investors, all of this adds up to a recipe for stress, since the loonie and the price of oil have become tightly linked. If Kemp is right, stock prices, oil prices and the loonie are all likely to rise -- or fall -- in sync. Rather than reducing the risk in your portfolio, a hefty weighting of oil stocks may intensify it. So long as oil prices are going up, you'll love the results -- but just watch out for that inevitable step down.
Author: Ian McGugan
