Updated with correction
Institutional investors are seeing short-term gains from their recent commodity investments, but those gains could be overshadowed by an economic catastrophe if political turmoil overseas causes a drop in demand or an oil price spike to more than $200 a barrel, investment experts say.
And there's a lot that could spark a drop in commodity values —a protracted civil war in Libya, spreading democracy movements in the Third World, civil unrest in China and Pakistan or a shaky financial system in Europe.
For now, the soaring price of oil spurred by unrest in Libya has helped institutional investors that bumped up their commodities allocation, notably in energy, see early positive results.
The Dow Jones UBS Commodity Index closed at 169.15 on March 4, up 26.3% from 133.94 on March 4, 2010. The index was up 0.36% for the first two months of this year.
Investors had increased their investments in all types of real assets, including commodities and energy-related investments. Commodity investments, for example, grew 97% in the 12 months ended Sept. 30, 2010, to $18.3 billion, while energy investments increased 188% to $5.7 billion (Pensions & Investments, Feb. 7).
Overall, institutional investors heaped $8 billion into commodities in December alone, according to a recent Barclays Capital report. The study estimated net institutional inflows of almost $46 billion, which amounts to three quarters of the total inflows of $62 billion flowing into commodities for the year.
“Commodities have had a fantastic year. 2010 was the year for commodities in that if you bought commodities in 2009 and held to 2010, in a lot of categories you are above 100%” with returns more than doubled, said Scott Minerd, chief investment officer in the Santa Monica, Calif., office of investment management firm Guggenheim Partners LLC.
But a rapid increase in oil prices above $200 a barrel or a global political crisis could cause a worldwide disruption in demand for goods and services. “Even though the cyclical outlook has surprised many to the upside, there are multiple potential `jump risks' that could quickly short-circuit the post-crisis recovery — particularly in the geopolitical sphere. ... If oil is priced at over $100 a barrel because the global economy is firing on all cylinders, there would be no story,” said Nathan Sandler, co-founder and managing partner of ICE Canyon LLC, a Los Angeles-based emerging markets investment firm. ICE Canyon is a joint venture with Canyon Capital Advisors, an alternative investment management firm.
Instability in Pakistan is not a distant possibility, he said. “There are markers showing a government in Pakistan that is barely in control,” Mr. Sandler said.
The problems aren't exclusive to the Third World. The European financial system is very weak and vulnerable, held together with heavy intervention and support from the European Central Bank, he said.
Austerity programs in European countries such as Portugal, Ireland and Greece could lead to a backlash among their citizens and a potential for social instability, Mr. Sandler said. What's more, nobody knows whether the pro-democracy movements in the Middle East will spread. China, Venezuela, North Korea and Cuba could possibly be vulnerable, creating “contagion risk,” he said.
“Widening political instability that disrupts the oil supply, destroys production or closes strategic transport routes ... would create a different kind of "jump risk' for the global economy,” he said.
Still, for now, governments' fiscal and monetary stimulus packages have produced higher returns, Mr. Sandler acknowledged. Many countries are already employing all of the fiscal and economic measures available to right the ship rocked by the 2008 recession, he said. This leaves them nothing else to pull out of their hat in another meltdown.
Newer investment sectors such as alternative energy could gain from disruptions in the global oil production, said Michael Stark, founder and general partner of alternative investment firm Crosslink Capital, San Francisco.
“We have choices now other than oil we did not have before,” such as natural gas and plug-in hybrids, Mr. Stark said. ”We think those choices will flourish.”
Social unrest could cause the governments of oil-reliant nations around the world to look at energy self-sufficiency, causing them to create subsidies, Mr. Stark said.
Larry Thrall, managing director of Vireo Energy, a Malibu, Calif.-based clean technology financial consulting firm, agrees that the “big winners will be renewable energy and natural gas.”
“I think we will see a big push for energy independence,” he said.
Italy, which gets a big portion of its oil from Libya, already has taken a step toward converting to solar energy with a feed-in tariff program. Vireo Energy is helping Solar Investment Group, a Milan-based solar energy developer, raise it second and third funds that take advantage of Italy's solar subsidy program, Mr. Thrall said.
Most investment analysts are watching to see whether the pro-democracy uprisings continue to spread. “Our position all along is that Saudi Arabia (and Kuwait) are the line in the sand,” said Alec Young, international equity strategist at New York-based rating agency Standard & Poor's. “The reason we are feeling sanguine is that Saudi Arabia and Kuwait are wealthier than countries like Egypt.”
Saudi Arabia and Kuwait have been taking countermeasures such as giving workers pay increases and interest-free loans to avoid civil unrest, he said. “Having said that, it is not an exact science,” Mr. Young said. “$100 a barrel for oil is not a big deal to the economy. If the unrest spreads to the Gulf States, oil prices could spike to $200. ... That would be a game-changing type of event.”
Institutional investors in alternatives are also concerned that higher oil prices would hurt economic growth, thus damaging private equity company values.
So far, consultants for alternative investments have not seen a reactionary boost to commodity or energy investments resulting from the turmoil overseas.
“I haven't seen any action based on that on the private equity side.” said Mario L. Giannini, chief executive officer of alternative investment consulting and fund-of-funds investment manager Hamilton Lane, Bala Cynwyd, Pa.