To look at the markets, you really wouldn’t guess that they’re balanced on a knife-edge.
After all, at first glance, equities are riding high. Sure, that may be on the back of dovish (low interest rates) central banking, but many investors – myself included – are happy to surf this wave of artificial optimism.
But meanwhile in the background, geopolitical tensions are on the rise – whether Isis in Iraq or the unfolding situation in Ukraine.
And now Saxo Bank’s chief economist, Steen Jakobsen, has warned us about a side effect of those tensions that could whip the rug right out from under the markets – something that could lead to a deadly combination of high energy costs, higher interest rates and inflation.
What could it be? Over to Steen: “The simplest way to ‘measure’ geopolitical risk is to look at the price of energy. Energy is everything…”
The price that can make or break a recovery
Energy – in particular, the price of Brent crude oil.
The price of Brent matters, because economies are so energy-dependent that higher costs could cripple the world’s delicate economic recovery.
Thankfully, the oil markets have seemed relatively sanguine lately – in no small part because US production increases have taken the sting out of a Middle East supply crunch.
But let’s not delude ourselves. Just remember how volatile oil can be.
During the Arab Spring, prices were up at $128, and a few years before that, we were up at $150. At the time, some commentators were even speculating we’d go to $250!
In my opinion (and that of Opec, the group founded in Iraq in 1960 to protect the interests of producer nations), the days of sub-$100 oil are gone. The only question is, how much higher can oil go?
Well, that’s a question nobody knows the answer to. But we do know what will happen if it shoots up.
A deadly combination for economies and stock markets
Right now, everything looks kind of rosy for Western investors: low inflation, stable energy prices and relatively strong currencies.
Now, let’s invert the situation: high oil prices lead to higher inflation; high inflation trashes currencies and sends central bank rates higher. High energy costs, higher interest rates and inflation: a deadly combination for economies and stock markets.
Stock markets crash, everyone feels poorer, bad debt explosions cause another banking crisis – confidence is sapped and hey presto, we’re back in 2008!
Of course, this isn’t a prophecy. It’s just a possible scenario.
And there’s some good news – while a spike could be awful for global markets, you and I can do something. We need a hedge.
Protect yourself from an oil price spike
Since there are still massive risks of a crude oil price spike, and because I definitely want to hedge my equity portfolio (ie, if my equity portfolio goes down, I want something else I own to go up), oil remains a strong buy for me.
Far easier than buying physical barrels of crude oil is buying future contracts on the stuff, and even easier still, is buying an exchange-traded fund (ETF) that buys the contracts and periodically rolls them over.
That’s why I proposed a Brent ETF back in September 2012.
It’s been a fantastic hedge. Even though oil hasn’t spiked (and the markets haven’t crashed), it’s been ticking away nicely, making money out of a market anomaly that essentially means it’s buying discounted contracts and selling them at higher price.
Here’s how it works…
ETFs that buy low, sell high
In a crude oil ETF, the fund manager buys contracts for oil with a delivery date in the future – say, July next year.
Now, because he doesn’t want to take delivery of the oil, he’ll have to sell the contract before July 2015 – or else he may end up with a boat-load of oil to pick up at Felixstowe!
With the proceeds from the sale of the future contract, he buys a new contract, with delivery for July 2016. The process is known as ‘rolling over’ the contract, and it means the fund always has exposure to the oil price.
Better still, with the oil markets being so overly optimistic, they’re still pricing in price falls going forward. That means the ETFs currently sell at a discount to the going rate for oil.
Over the last couple of years, this market anomaly known as ‘backwardation’, has meant that my ETF has been profiting not only as the oil price is slightly up, but because the ETF has been buying discounted contracts, and selling them at spot rates at the time of rollover. To use the jargon, it’s called a ‘positive roll yield’.
Even if you don’t fully understand how it works, the point is that I expect this situation to continue. What’s more, if tensions in the Middle East flare up, then the price of oil could rocket.
You could even make money in a flat market
As I’ve explained, a hedge can make money even if oil prices remain flat. Though backwardation is less than it was a year or two ago, it’s still there – and that’s a bonus.
The spot price for Brent is currently around $107, yet a futures contract a year from now is $106 and a year on from that, it’s down to $102. If trouble erupts, just imagine how high those longer futures contracts could go!
There’s a surprisingly large selection of oil ETFs to choose from. You can get some ideas here. There’s a choice of dollar or sterling exposure. Near-term futures, or further out.
It can get quite complicated. There’s heating oil, petroleum, or crude. There are long, or short funds, and even funds that are twice leveraged. If you decide to invest this way, choose wisely! And if you’re unsure, it’s best to seek independent advice.
You might have been surprised by my optimistic stance on the FTSE over recent years, but make no mistake, my equities exposure is hedged – not 100%, but I’ve got insurance. As well as oil, I’ve spoken about a global reinsurance fund, CatCo.
As a long-term investor, it doesn’t pay to be overly pessimistic. But there’s no harm in preparing for all eventualities.