Pension Funds Tarred in the Oil Pits

June 2008 By GIRARD MILLER

Have public funds perversely spurred inflation?

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As oil prices surged beyond $130 per barrel this month, the media picked up on the presence of pension funds in the oil markets. There are several spins on this story. First, there is the question of whether pension funds are driving oil prices higher through their involvement in commodity markets and index funds. Second, there is the concern that pension funds are now playing in a "bubble market" that will lose money when the inevitable speculative blow-off occurs, just as they did with the Internet bubble of the 1990s.

Part of this media storm reflects the growing American need to blame somebody for high oil prices while fretting about the world coming to an end — either from a collapse of petroleum-dependent economies or a collapse of the bubble. Blame and worry: They both sell newspapers and make great TV hype. But they don't yield much insight into what pension funds should prudently be doing in the face of this global adjustment to higher demand for natural resources.

Let's start with the basics of supply and demand. There is no question that global demand for commodities is growing and will continue to grow. The emerging markets in China, India and Brazil virtually guarantee that demand for food and petrol will escalate in the coming decades. India's Tata Motors is building a $2,500 car, and the Chinese are constructing a national highway network as extensive as the U.S. Interstate system. Put a few hundred million people into those cars and onto those highways, and you'll see global demand for oil skyrocket. Meanwhile, the reserves in the Middle East cannot expand enough to meet this new demand for very long, so global prices are increasing in anticipation of future supply-demand imbalances. Higher prices will bring on more supply, encourage alternative energy sources and curb demand. Commodity futures markets provide immediate "price discovery" for that future equilibrium level, as reflected recently in the price for oil to be delivered in 2016.

Yes, there has been speculation in the oil trading pits, but the price movements can't be blamed on speculation alone. Statistically, 87 percent of the price of oil can be correlated with the growth of the U.S. money supply (M3), which means that monetary inflation and the demise of the dollar are the real culprits that average citizens simply don't understand. When oil prices rose earlier this month, it wasn't because a dozen greedy speculators cornered the market. It was because Israel rattled its sabre and hinted at an air strike on Iran, reminding everybody that we still have geo-political risk in the Middle East that could drive prices beyond $200 a barrel if antagonists over there get crazy.

In the agricultural commodity pits, it’s the same story. Global drought has caused wheat supplies to dwindle to the lowest level in decades, Midwest floods have pushed corn prices to all-time highs, and demand for protein by Asia’s growing middle class has driven prices of grains up dramatically. Add the artificial demand of subsidized corn-based ethanol to the mix, and we get grain prices at double their former levels.

As to the role of pension funds in the last year's rise in prices, there is no question that the long-term investments by public pension funds have added to the "paper demand" for commodities. But these are not trading accounts. Pension funds are not buying one day and selling the next. They are simply taking a long-term investment position in commodities in an effort to diversify their returns (and thus reduce total portfolio risk) and to capture at least a little hedge against inflation.

Pension funds have a huge "COLA" liability if inflation increases, so their investment portfolios must be constructed to provide a hedge against that risk. Unfortunately, financial assets, especially bonds, typically fare badly during periods of inflation, so a mix of commodity investments is a wise choice for pension funds. This means that as a long-term asset, commodities as a class do belong in most pension portfolios.

That said, there are two issues that should concern trustees and pension professionals in light of today's markets. First, there is a genuine risk that these markets are topping out short-term — after causing a recession that forces prices to plummet. That would produce negative returns on commodities and negative returns on pension investments in other markets such as stocks. The more the pension funds jump into this game right now, the greater the risk that could happen. Second, the index funds and futures strategies that pension funds are using now may not be the most efficient vehicles for investment purposes.

The argument that we're getting close to a blow-off top in commodities has already attracted media attention and commentary. The potential impact on pension funds has likewise been heralded as a growing risk. George Soros, the legendary hedge fund wizard, and a man with immense market experience and wisdom, has testified before Congress that a "bubble is in the making" and commodity index funds are not a legitimate asset class for pension funds.

Only time will tell whether Soros is right on principle about the role of pension funds in the commodity index and futures markets. But there is another issue for pension fund trustees and administrators to address right now, at least with respect to the oil market. The indexes and futures may not be the smartest vehicles for pension funds to use, even if they seek to add portfolio exposure to the asset class.

Here, my analysis is pretty simple-minded, but I have studied this issue extensively and participated actively in the petro futures and oil-industry equity markets for many years. I've now taken partial profits on long-term holdings in some situations that today look overvalued and overpriced. My research suggests that the oil royalty trust market and the petro sector of the stock market are where pension funds can most efficiently link their money to future long-term petroleum economics and do so at far less fundamental risk than in the commodity pits. This is where the value investors will practice their craft.

In today's market, the oil royalty trusts — both U.S. and Canadian — are trading at stock prices that value oil at $75 to $80 per barrel, not $130. Likewise, the major oil companies are trading at assumed oil prices well below the futures contracts. In fact, some savvy and gutsy hedge funds are selling oil futures and buying oil producers and royalty trusts. And unlike commodity futures that pay no dividends, some of these equity securities pay handsome dividends and royalties that can pay for retiree pensions.

If pension funds want to work the futures market on a long-term basis, they should shift their focus from the nearby contracts for next-month delivery, and instead buy and hold the long-term deferred contracts. At today's levels, a 2016 contract at $136 per barrel looks like a much better bargain to me after considering the odds of more inflation, the "Chinese road" story, the time value of money and the fact that margin can be held in interest-earning Treasurys.

Pension fund CIOs need to have a serious talk with their money managers about ways to best gain protection from or participation in commodity inflation. Right now, the indexes and the 2008 futures contracts are speculations and not investments.

Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. More biographical information.