Triple digit oil is here to stay, says Threadneedle

Having been a little over $20 at the outbreak of the second Gulf War in 2003 and just over $50 at the start of 2007, the price of a barrel of oil broke through $100 at the end of February and has carried on rising since.

While industry analysts are predicting a retrenchment below $100, Threadneedle believes that this view is naïve.

Dominic Rossi, Threadneedle's Head of Equities, says "Oil analysts have been consistently behind the curve as the oil price has risen and we think they are still behind the curve now. We can't see oil falling below $100 from here and it's time investors accepted triple digit oil and started positioning portfolios accordingly."

Sustained high oil prices have many implications at the sector and geographical allocation level in equities, explains Rossi. "At the country level we are seeing a massive transfer of wealth from oil importing nations to oil-rich countries, and the big winners in this regard are markets such as Brazil and Russia. Brazil's recent achievement of an investment grade rating from S&P is a good example of how natural resources can transform a country's financial position. The losers are countries such as the US, which consumes 25% of world oil but produces just 8%, and Japan, which consumes 6% and doesn't have any production."

In terms of sectors, Rossi sees plenty of opportunities: "As ageing oil reserves run down and the search for new reserves pushes into ever harsher territory, specialist oil services companies are set to benefit. The North Sea oil fields of the 1980s were in 100 metres of water but new discoveries like Tupi off Brazil are 2km below the sea, with a thick layer of rock to get through as well. These inhospitable conditions call for specialist equipment, and supply/demand imbalances mean that the suppliers of this kit are price setters."

The opportunities are not just limited to oil industry plays, however: "As these countries get richer and credit becomes more widely available, we are also seeing the development of consumer-related sectors like retail, real estate and mobile telecoms," continues Rossi. "Meanwhile, governments are using oil profits to rebuild infrastructure on a grand scale. The companies supplying these programmes, such as heavy equipment manufacturers, steel companies and cement producers, are all overweights for us."
There are further implications for investment strategy at the economic level, as Threadneedle's Head of Government Bonds Quentin Fitzsimmons explains: "High headline inflation rates are due in no small part to high energy prices," he says. "The divergence between weak consumption, subdued wage pressure and high energy and raw materials costs makes for a wide range of potential outcomes for inflation in the future. Will demand destruction set in or will high energy costs eventually push us into a wage spiral? The inflation picture is finely balanced."

As far as strategy is concerned, Fitzsimmons acknowledges that sustained inflation may make current low government yields difficult to justify. "There is a chance that markets are being complacent about inflation," he states. "Economic weakness and risk aversion have been key supports of government bonds over the past year, but once growth and confidence start to recover, negative real yields might not last long. We will endeavour to use this interesting situation to our advantage."