February 27, 2012 / 9:16 PM / 8 years ago

Protect your investments from oil shocks

He’s back. The speculative trading beast is pushing up gasoline, diesel and heating oil prices, and scaring economy-watching investors in the process. There are a few defensive weapons to protect your portfolio. It’s time to unsheathe them.

Oil traders, producers, refiners and speculators, citing tensions in the Middle East that could cut supplies, have once again revived the monster. Crude prices hit a nine-month high recently to top $120 a barrel and gasoline has spiked by as much as 40 cents in some regions of the United States. The national average price of gas could hit $4 to $4.25 per gallon by April, according to Tom Kloza, chief oil analyst at Oil Price Information Service.

The overall impact is felt everywhere. For every penny increase in the price of a gallon of gasoline, spending declines an estimated $1 billion throughout the United States, according to the energy research firm Cameron Hanover. At this point, that could kick the crutches out from under the wobbly U.S. economy.

Wall Street and derivatives traders have taken to the courts to block new rules curbing speculation through “position limits,” so prices remain free to go stratospheric again.

There is no limit to how many contracts traders can trade on any one commodity, nor are there limits on extreme price movements. The Commodity Futures Trading Commission approved rules which would institute position limits, but in December, the Securities Industries and Financial Markets Association and International Swaps and Derivatives Association — two trade groups representing bankers, brokers and traders — filed suit to block the rules. The matter is pending in federal court.

The stock market, in contrast, has certain “circuit breakers” triggered by large price swings, particularly declines.

Every commodity, from corn to rice, can be a target of speculation, and price movements may have nothing to do with supply and demand data.

The last time we saw this speculative feeding frenzy was in 2008, when in July, amidst the meltdown in the credit and housing markets, speculators wildly ran up the price of crude oil to over $140 per barrel.

Was the steroidal price explosion in 2008 due to increased demand or a significant reduction in supply? Trading volume was nearly 15 times world oil demand that year, according to research compiled by Americans for Financial Reform. It was as if commodity traders had opened up a mammoth casino and all made the same wager, constantly outbidding each other in a time of turmoil. Late in 2008, oil prices collapsed after the credit and housing meltdown, when it became apparent that a major recession was coming.

Of course, speculative bubbles eventually fall back to earth like Icarus, the mythical boy with wax wings. Oil prices crashed to around $40 a barrel by the end of 2008. They have been rising

since then, even though most major economies are hobbled by modest to poor economic growth.

“The only short-term solution,” says Tyson Slocum, director of Public Citizen’s energy program, is to “rein in speculation.” He notes that due to increasing global demand for oil and the difficulty in accessing crude cheaply, “addressing speculation won’t get us back to $2.50 a gallon, but it may shave 50 cents a gallon off current prices.”

What can investors do to protect themselves? Other than to badger the Commodity Futures Trading Commission (www.cftc.gov/Contact/index.htm)

to enforce and strengthen its trading rules, you’ll need to keep an eye on your portfolio. You can hedge oil price increases with exchange-traded funds (ETFs) linked to energy prices such as the iShares S&P Global Energy Sector Index (IXC), which tracks energy prices throughout the world, or the SPDR S&P Oil and Gas Exploration and Production Index (XOP).

Do not try to time the market with these funds. Any trend is notoriously difficult to time, and many professionals guess wrong. While these funds don’t perfectly track oil prices, they invest in passive indexes of companies in the industry. In the past, they’ve been reliable gauges of profits in the petrochemical sector.

You’ll also need to keep an eye on inflation. As fuel prices creep upward, threats of inflation affecting the value of your nest egg for now and for retirement become more and more real. This is why any strategy focused only on energy prices misses a larger point. Investments may also need a reliable inflation hedge.

Inflation protection is easy to find and should be at the core of your hedging strategy against higher oil prices and higher cost of living.

You can purchase inflation-indexed bonds through the U.S. Treasury's TIPS bonds (here)

or through an ETF that is managed to beat inflation such as the IQ Real Return (CPI). These vehicles should accompany broad-based stock and bond index funds such as the Vanguard Total Stock Market Index (VTI) and the iShares Barclays Aggregate Bond Fund (AGG), the latter which I hold in my 401(k) as a proxy for the entire U.S. bond market.

As if you didn’t have enough to worry about, I would also monitor how the oil shock — if it proves to be persistent — will impact global economies from Beijing to Boston.

The key question is how much oil prices will hurt recovering economies like the United States and contracting markets in Europe. It’s too soon to say. It’s worth noting, however, that Americans are consuming less gasoline than they did in 2008, and are buying more fuel-efficient vehicles. New fuel efficiency rules from the Obama Administration will help. The SUV age may be behind us.

As far as your portfolio is concerned, ensure that you have inflation protection through inflation-indexed securities, and that your allocation is appropriate to the amount of market risk you can stomach. Nobody can tell the future, but any strategy that doesn’t include capital preservation is a bad one.

(The author is a Reuters columnist. The opinions expressed are his own.)

Editing by Linda Stern and Andrea Evans

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