Oil looks cheap, but investors are wary

LONDON Tue Dec 23, 2008 5:00am EST

An offshore drilling platform is seen in the Black Sea on the West coast off the Crimea in this March 2008 file photo. REUTERS/Handout/Files

An offshore drilling platform is seen in the Black Sea on the West coast off the Crimea in this March 2008 file photo.

Credit: Reuters/Handout/Files

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LONDON (Reuters) - A flight into cash during the credit crisis has helped drive oil and other commodity prices down so steeply that they are a potential "buy" for pension funds with a longer view.

But timing is everything.

"People are sitting on cash -- big lumps of it," said Mark Mathias, chief executive of commodity fund manager Quantum Asset Management. "Everyone is worried about when to go back in. Long-term, oil is cheap, but who knows where it goes in the short term."

Investors are searching for evidence that could signal whether the global downturn may be near to the bottom.

In these troubled times, the Baltic Freight Index has become a key leading indicator of economic vitality.

"The Baltic Freight Index is the electro-cardiogram for the world economy," said Hilary Till, principal, Premia Capital Management.

The Baltic Exchange's main sea freight index .BADI has risen over the last 10 days, but prices to ship commodities are still near their lowest in more than two decades.

"When you are in an extreme state, the things you follow are indicators for the overall health of the world trading system or the banking system," said Till, who is also research associate at the EDHEC Risk and Asset Management Research Center.

MORE DE-LEVERAGING

Investors have dumped commodities along with other financial assets after a crisis in the banking system seized up global markets and tipped the world economy into recession.

There is still more de-leveraging to come.

"Liquid assets are still in the firing line to be sold," said Mathias. "I think a lot of pension fund money left the (commodity) indexes in general, but quite a lot is actively planning to come back in."

If pension fund investors come back, they would be more likely to opt for more dynamic strategies rather than long-only investments in commodity indexes, which are used to gain access to the asset class.

"Some investors are looking at non-directional stuff, such as market-neutral hedge funds," said Mathias.

The California Public Employee Retirement System, for example, may consider investment strategies in commodities beyond commodity indexes such as the S&P GSCI .SPGSCITR.

Pension funds and other institutional investors moved into commodities in the past 5 years to provide portfolio diversification versus equities and bonds.

Total commodity assets under management reached $270 billion by the end of the second quarter this year, according to Barclays Capital.

Some of this money has gone as prices plunged. Oil, for example, is down more than $100 a barrel from its peak above $147 in July.

Barclays estimated commodity assets under management fell more than 30 percent in the fourth quarter to $144 billion from the previous quarter, mainly due to price declines.

Commodity indexes, investment vehicles based on baskets of various commodities, have suffered big losses.

The S&P GSCI, for example, is down 48.8 percent since the end of last year, partly because the index is 65.5 percent weighted to energy.

FALLING KNIFE

These sharp falls may provide an entry point for investors.

"The price correction may entice these (pension fund) investors into the market," said Richard Cooper, a partner at consultants Mercer, adding that they will be wary of "catching the falling knife."

He also said there could be some skepticism among pension funds that had bought into the commodities "super-cycle" theory that relied on China remaining an economic powerhouse even if the industrial world sank into recession.

China has just cut interest rates for the fifth time since September to try to preserve economic growth.

Pension funds' total allocation to commodities is still small, estimated at less than 1 percent of total pension assets, according to Cooper, who said some prospective investors had held off because commodity prices were so high.

(Additional reporting by Pratima Desai and Stefano Ambrogi, Editing by Peter Blackburn)

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