Investments  

Resources View: Oil proves useful hedge

Nick Sketch

Most commodities have seen weak prices in the past year or two with natural gas falling as shale production rises, and base and precious metals weakening.

Commodities have often acted as a good long-term hedge against rising inflation, and may do so again.

Given our longer-term fears about inflation, and given that new oil, gold and iron cannot just be printed in the way that new dollars can, we believe that many portfolios should have some exposure to commodities.

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Market prices today assume that oil will fall from today’s price of about $107 to $82 in the next six years, which seems unusually extreme.

Any increase in geopolitical risks or the threat of major trouble in the Middle East, such as Syria, could be a trigger for weak equities, a strong dollar and a strong oil price.

The latter could represent both a further drag on growth and profits (bad for most equities) and a boost to inflationary pressures (bad for bonds).

This means that direct exposure to the price of oil (not the share prices of oil-producing companies) may well be a useful strategic hedge for many portfolios based on equities or equities and bonds together.

As a result, we have been looking to move defensive commodity investments to a new structured product that will return 100 per cent of the purchase price if the oil price falls, but will return a substantial profit on any increase in the oil price from today’s levels during its life.

Having examined the options available, our choice for a structured product in this area comes from Société Générale.

While daily prices will fluctuate, the long-term risk is to Société Générale’s credit, where a senior default looks very unlikely.

The long-term debt of the group is currently ranked A by S&P, A2 by Moody’s and A+ by Fitch. Assuming the bank does not fail utterly in the coming years, the note will return at least the launch price of 100p at maturity. It is also traded daily and is an eligible investment for Isas and Sipps.

Although the note is priced in sterling and offers a minimum return at maturity in sterling, oil is priced in dollars. Thus, the oil price seen by a UK investor can rise either because the headline price rises or because sterling falls against the

dollar.

To maximise its usefulness as a defensive holding for UK investors, this note offers returns based on the performance of oil in sterling, so gains are sensitive to the £/$ exchange rate as well as the formal benchmark of the WTI (West Texas Intermediate) oil price.

The current participation rate is 300 per cent with no averaging or caps to the possible gain. So if the spot oil price in sterling rises by 20 per cent in the six years (ie about 3 per cent a year on average), the note’s price would rise by 60 per cent (about 8 per cent a year).