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What do rising oil prices mean to your portfolio?
Exporters and foreign producers may be best hedge

A couple of weeks ago, I wrote of the risk in technology stocks. However, another risk has been lurking for nearly two years and has just recently started to rear its ugly head - crude oil prices. Oil prices started rising early in 1999 and embarked on a 40% rise over a two-month period in the spring of that year. During the past 18 months, the price of crude oil has continued its rise, albeit in volatile fashion. Many investors wonder about the implications of still higher crude oil prices and the potential impact on investment portfolios.

Cause of rising oil prices

Commodity prices, much like the price of most products, are governed primarily by the forces of supply and demand. When consumers demand more than what is supplied by producers, a shortage exists and the price gets pushed up - and vice versa. At the end of 1998, oil had just capped its third straight year of bulging world surpluses and swelling reserves. In fact, 1998 saw an unusually large world surplus of 1,485,000 barrels per day (the typical measurement for oil production and consumption) - nearly ten times the 1997 surplus. Big surpluses depressed prices, which prompted OPEC (Organization of Petroleum Exporting Countries), along with most producers, to drop production during the latter part of 1998 and into 1999. But 1999 saw a complete 180-degree rotation as demand for oil surged in the midst of the production cuts. The result was a huge shortage of 1,325,000 barrels per day. Once the market realized demand would persist, prices began rising quickly.

Political Risk

The United States' often strained relations with some of the Middle East's biggest oil producers (Iran and Iraq) always enters politic risk into the picture and exposes all nations to inflation risk (especially exporter like the US, Europe and Japan). Mid-East nations are, as a group, the largest oil producers in the world - accounting for more than 30% of the world's production. Hence, when production levels are cut by the world's richest oil nations, net importers (like the US) are most at risk of adverse economic consequences. Most of the US's largest trading partners (excluding Canada) tend to be net importers of oil themselves, so the US depends on Mid-East producers to meet demand. A quick peak into history clearly illustrates how political factors can affect prices. The Iranian revolution roughly twenty years ago saw oil prices pushed up to US$72 per barrel in 1999 dollar terms. The Gulf War just ten years ago saw crude near the 1999-equivalent of US$31. Today's price of US$32 puts the current situation in proper historical perspective.

Impact of still higher prices

Some analysts are forecasting a continued strong rise in the price of oil. The impact on our economy could be seriously negative if shortages (and hence high prices) persist for extended periods. While energy prices haven't yet pushed inflation into dangerous territory, it has bumped it up to one of the highest figures in years - approximately 3%. While core inflation (inflation excluding food and energy prices) remains under 2%, persistently high oil prices would eventually filter through the rest of the Canadian economy by raising the costs of doing business to all sectors. Will oil prices remain high (or keep rising) for an extended period? Nobody can predict the future so I'm not going to try - especially with something so volatile and subject to politics. But there are a few steps you can take to give your portfolio a hedge if energy costs concern you.

Boost exposure to energy stocks

This is the simplest way to hedge higher energy costs. Buying shares in oil companies ensures that at least a portion of your portfolio will benefit if energy costs continue to soar. Energy producers (like Talisman Energy and Nexen) provide the best leverage to rising prices since they can usually pass on the full price increase onto their customers. However, integrated companies (like Suncor and Petro Canada) also sell to retail consumers and may have to "eat" some of the increased costs (at some point) rather than pass it on in the form of higher gas prices. There are a few ways to get this type of exposure.

Some investors may simply want to buy energy stocks directly. Whether it's through a full service or discount broker, pay particular attention to the company's prospects, cost structure, and stock price in relation to the company's cash flow per share. Since unique tax benefits are available to energy companies, earnings are not very reliable. So I'd recommend you study the company's cash flows over a number of years along with the stability of the company's management.

Personally, I'd prefer to see investors get exposure to this sector through mutual funds. Though energy is typically the largest sector in natural resource funds, it's rarely the sole focus. The best mutual fund hedge can be obtained by investing specifically in the more focussed energy funds. My top picks in this tiny category include Royal Energy and CIBC Energy. With energy stocks, management is crucial and Gordon Zive (Royal) and Paul Wong (CIBC) know the who's who in the oil patch. If you want broader diversification that will also include precious metals and exposure to other resources, AGF Canadian Resources, Fidelity Focus Natural Resources, and Signature Canadian Resource (C.I.) are fine picks in this broader category. Though I believe good actively managed funds can add tons of value in this category, thrifty index investors now have a passive way to play the energy sector. Last week, Barclays Global Investors Canada launched the iEnergy fund - an exchange traded fund which tracks the S&P/TSE Energy Index. Fees are dirt cheap at 0.18% per year but you get no active management and no evaluation of any qualitative factors (very important in this sector).

The other option is to buy Royal Trust Units (RTUs). These are more complex and don't offer the growth potential available to stocks. The lack of growth stems from the fact that RTUs pay out all of their income, whereas an energy company will retain most of its cash flow for internal growth purposes. Since RTUs lack the ability to produce much growth internally, they are even more sensitive to commodity prices than most energy stocks.

Reduce Asian equity exposure

Since Asia and the Pacific Rim are big consumers (and net importers) of oil, the fragile economies of the Far East may be most susceptible to further oil price spikes. While this region accounts for 11% of the world's oil production, it accounts for nearly 30% of total world oil consumption. In 1999, Asia and Pacific nations were net importers to the tune of more than 12 million barrels per day.

While no hedge is perfect, some of these steps can soften the blow or produce gains should oil continue to rise. Before boosting exposure, take a peak inside of your current holdings to estimate your current energy exposure. If you prefer to hedge by simply moving out of equity investments altogether, cash (t-bills, very short term bonds, or money market funds) or real-return bonds (offer inflation protection) are two of the more conservative ways to cushion your portfolio.

NOTE: Many thanks to BP Amoco PLC, whose June 2000 World Statistical Energy Review was the source of the valuable supply and demand data highlighted in this article.

Disclaimer

This article is not intended to provide advice on, or promote, the investment merit of any individual equity securities. Before taking any action, investors should consult a qualified professional.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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