New alternative as oil’s slick and gold shines

Wealthy investors used to perceive an allocation to commodities as a form of portfolio insurance, as raw materials typically offered diversification, uncorrelated with traditional assets. But the recent bull run in prices of natural resources, which has seen a 20 per cent return over the last year, has led many private banks to rethink strategies recommended to clients, with commodities increasingly seen as a viable alternative, performance driven investment alongside property and private equity.

Of particular interest to wealth managers have been the staples of gold and oil. Both have performed strongly, with some analysts expecting further gains.

Michael Lewis, global head of commodities research at Deutsche Bank, says increasing demand from the US and China, under-investment in new production, limits to refining capacity and a forecast of extreme weather conditions this winter are sustaining a bullish price outlook for energy prices.

While oil prices averaged $20 (?16.5) per barrel in the 1990s and $34 during this decade, Deutsche Bank expects crude oil on the New York Mercantile Exchange to average $60 in 2006. Although Mr Lewis expects the price to drop to $45 in 2007, due to economic slowdown, oil prices are still expected to remain significantly above the levels of the 1990s. “In the long-term they will never fall below $40,” believes Mr Lewis.

Metal prices too have risen considerably. Copper has more than doubled over the last two years. Gold price has increased by 60 per cent in the past five years, from $254 to $472 an ounce.

Ross Norman, director of thebulliondesk.com thinks that external factors such as ongoing geopolitical tensions, the prospect of inflation and a declining dollar, together with “very compelling supply-demand fundamentals” are conducive to high gold prices.

“Perhaps the most compelling reason of all is the oil price,” he says, explaining that over the last 60 years, the typical ratio of gold/oil has been one ounce of gold to 16 barrels of oil. Currently, it is 1:7.

Stabilising oil

“If we take as correct Deutsche Bank’s forecast that oil will stabilise at $60 in 2006 and suppose the gold-oil ratio merely goes back to 10:1, this means the gold price should be $600 an ounce. If it goes back to its historical ratio, it should be above a $1000,” says Mr Norman.

Deutsche Bank’s Mr Lewis expects gold to be outperforming oil by the middle of 2006. “We have a very bearish view on the dollar and that is really driving our high in the gold price,” he adds.

But investors also need to be conscious of volatility. A typical equity may have a volatility of between 15 and 20 per cent, much lower than the 80 per cent swings associated with crude oil or natural gas. Investing in a basket of commodities is less risky, as a commodity index has the same volatility as an equity fund.

During the last four years, all commodities indices have performed well, particular those with a heavy energy weighting such as Goldman Sachs Commodity Index (GSCI), which currently has 80 per cent exposure to energy. The other main benchmarks include the Dow Jones-AIG Commodity Index, The Deutsche Bank Liquid Commodity index, The Rogers International Commodity Index, S&P commodity Index and the Reuters CRB Commodity Index.

However, as Mr Lewis points out, the risk of investing in a commodity index is greater now in an environment of high oil prices “as the sources of return of a commodity index are all now in the spot return of energy. You are putting all your eggs in one basket.

“Looking into next year that has become a big danger, because if we continue to have disappointing performance in aluminum, or the agricultural side in particular, the ability to extract positive returns does become a lot harder.”

Deutsche Bank has built a new, reverting version of its own Commodity Index, in order to take into account long-term cycles in prices. It has an in-built mechanism which records the one-year average price of the commodity, comparing it to the five-year average and, as that commodity becomes more and more expensive compared to its long-term average, it starts to reduce its allocation to it.

Two years ago, the mean-reverting version of the Deutsche Index had 50 per cent in energy, which has come down to 27 per cent at the start of this year. Now, because the crude oil price has gone up to $70, it has just 8 per cent. “It is under-weighting very expensive commodities, and over-weighting very cheap ones like corn and wheat,” says Mr Lewis.

This clearly shows that the strategists behind the index feel there is a significant risk involved in buying oil at current prices. There are also rising concerns about lower levels of economic growth next year, in North America in particular, and that demand for commodities coming from Asia, and especially China, could slow down.

Lewis: next year could be dangerous