High-alpha funds are laid low by rocketing oil prices

Last week Fund Strategy wrote how Richard Buxton’s pro-cyclical Schroder UK Alpha Plus fund was suffering at the hands of the current oil situation. He claims it has led to market uncertainty and has created a gap between corporate fundamentals and share price performance.

Consequently Buxton (pictured below) – who took a call to be underweight in oil-related stocks – has seen his fund fall to the foot of the IMA UK All Companies sector over the past three months. However, he is not alone. The Gartmore UK Focus fund, managed by Ashley Willing, has also suffered recently because of a positive stance on cyclical companies and a lack of exposure to oil.

Willing (pictured above right) notes that, despite the slower economic growth created, the oil price remains low by historical standards. Indeed, he says the increase has been modest by the standard of previous oil price shocks. While inflation may tick up, he does not see it feeding through to higher wage growth.

As both Buxton and Willing will not be changing their stances as a result of the current environment, both funds may be set for further underperformance if the oil price stays strong.

Jay Bhutani, energy analyst at Credit Suisse Asset Management, believes this will indeed be the case and says that at current levels oil prices have yet to peak: “The price of oil will continue to rise until demand gives in.”

He argues that for it to slow, the price needs to reach a point where consumers can no longer pay. “UK customers currently pay around 80p for a litre of petrol, which equates to $230 a barrel. The question is what petrol price would it take for consumers to stop using their cars?” Bhutani notes that while the current high cost of oil is having a negative impact on market sentiment, the market today is very different than it was when recession hit in the 1970s. “The UK economy is now far more flexible and less industry-orientated than it was in the 1970s and the customers are much richer. As a result, we should not immediately assume that a recession is the most natural result of the high oil price now.”

Likewise, Steve Thornbar, head of the global oil team at Threadneedle, says the fundamentals for oil are supportive going forward. He says the strong demand coming from China and India, combined with a limited amount of supply, will result in prices continuing to rise.

“While it is impossible to call how much further the price can reach, it is hard to see it falling substantially from here. Not only is there demand with limited supply; current geopolitical risk factors such as the war in Iraq and trouble in Nigeria are unlikely to subside soon. Finally, US inventories are falling and are likely to remain tight as we enter the winter season.”

This likely continued oil strength will impact on economic activity, Thornbar adds. Providing no terrorist attacks or political disasters strike, he says the price is likely to slide back into the $40s and consequently he is spending his time trying to find companies with the pricing power to cope with this.

These include energy and mining stocks, which produce the raw materials for the oil sector and so, he says, have the ability to pass on the higher prices. Conversely, he says: “If prices do increase it will start to have an impact on spending elsewhere and as a result the group is currently cautious on consumer-related stocks.”

One result of the higher oil price has been that many institutions have had to revise their global growth forecasts. Morgan Stanley Investment Bank’s famously bearish chief economist Stephen Roach says that after reworking its oil price assumptions, the bank has reduced its estimate for 2005 world growth by 0.3%, from 3.9% to 3.6%.

He says: “This relatively modest cut to our annual growth numbers masks a worrisome shortfall that we now anticipate in 2005 – a shortfall we think pushes the global growth rate down to its stall speed. As I see it, this anaemic growth rate could easily give way to outright recession.”

By Morgan Stanley’s thinking, the new equilibrium for oil prices is now in the range of about $30-40, which is well above the $20 a barrel average of the 1990s. Roach adds: “While we still assume a sharp fall-off over the next year back into the middle of this range, our new oil price profile is 8% above our previous assumptions for 2004. Additionally, it is 11% higher than what we had been assuming for 2005.”

On the back of this, while Buxton and Willing are avoiding oil stocks, Framlington UK Select Opportunities fund manager Nigel Thomas is heavily invested. He says: “All the G8 nations are growing at the same time and as a result we have seen the strongest growth in oil use for the past 15 years.”

Anticipating that oil prices will remain strong for the next two to three years, Thomas (pictured below) has increased his exposure to the oil and gas sector from 8% to 16% in the past 12 months. He notes that while there is lots of oil to be found in the world, the political risks in a number of oil-rich countries will keep prices high.

Thomas’s positive view on the sector drove his £295m portfolio to jump to seventh out of 296 funds in the IMA UK All Companies sector over one year to October 4, 2004. According to statistics from Standard & Poor’s, on a bid-to bid basis the fund made a return of 22.9% over the period, compared with a sector average return of 13.5%.

“For the first time I can remember it is the market setting the oil price, not Opec. Combine this with the fact that no new refineries have been built in the US since 1975 and you can see why I am confident on it going forward,” says Thomas.