May 30, 2008 / 3:05 PM / in 10 years

Oil bubble could prove threat to pension funds

By Matthew Robinson - Analysis

NEW YORK (Reuters) - Pension funds and other investors who rushed into oil through commodity indexes this year chasing big returns as other asset classes tanked could face steep losses if prices fall from record highs.

An avalanche of cash has rolled into commodities through simple long-only indexes this year, feeding the record-setting oil rally some experts say could be a bubble that is becoming more vulnerable to shifts in supply and demand fundamentals.

A sell-off in oil could spell big losses for the pension funds, municipal funds, college funds, unions and other groups that jumped out of equities-market plays and into the indexes, but have little experience or flexibility to deal with fundamental changes in commodities.

“A lot of the accounts that that have moved into commodities over the last 8-12 months clearly don’t belong in this forum,” said Peter Beutel, president of Cameron Hanover.

“It means that when this market turns, these people are going to get hurt, and they are going to get hurt badly, and there will be tons of lawsuits because they have no understanding how quickly commodities markets can turn and leave them in the dust,” he explained.

While many in the energy sector, such as U.S. Energy Secretary Sam Bodman, argue that fundamentals are driving oil’s rally, others say investment in commodity indexes has pushed prices beyond what supply and demand may justify, contributing to the 30 percent price rise over $130 per barrel this year.

“We are seeing the classic ingredients of an asset class bubble,” said Edward Morse, chief energy economist for Lehman Brothers. “Financial investors tend to ‘herd’ and chase past performance, comforted by the growing analytical conclusion that markets are tightening, and new flows, in turn, drive prices higher.”

Indexes such as the giant S&P GSCI and DJ-AIG offer investors a passive way to own a basket of commodities futures including oil, gasoline, metals and grains.

They sell front-month futures and buy second-month contracts, allowing them to make money when oil prices rise across the curve, particularly when front-month prices are higher than second-month prices.

Investors, exiting asset classes hit by the global credit crunch, have sought to cash-in on a six-year rally that has sent oil prices up sixfold to $135 a barrel this month as supplies struggled to meet rising demand from such emerging economies as China and India.

BUBBLE TROUBLE?

Some experts say much of the 30 percent rise in oil prices since the start of this year may owe a lot to the inflow of new money, and that fundamentals may not justify current prices.

Demand from big consumer nations like the United States has already faltered, and moves by some Asian countries to cut fuel subsidies could clip usage further. Prices could also fall with a significant rebound in the U.S. dollar, after weakness in the greenback sent speculators into oil.

“These are institutional investors who have said we have looked at all the things we can invest in and we decided it’s commodities,” said Sarah Emerson, director of Energy Security Analysis Inc.

“They are buying and holding and then buying more and holding more, and the physical market doesn’t discipline them,” she added.

Investment under commodities indexes has ballooned from around $70 billion at the start of 2006 to $235 billion in mid-April, about $90 billion of which has come from fresh financial flows with the rest coming from gains in the underlying commodities, according to Lehman Brothers.

Analysts said that while speculators such as hedge funds, which can be long or short markets, are frequently blamed for driving up prices, it may actually be pension and college funds investing money for average citizens that are helping cause fuel and food riots around the globe.

“Professional speculators are seen as the bad guys and pension funds are seen as the good guys, but it’s pension funds that are the bad guys,” said Olivier Jakob of Petromatrix.

With reporting by Barbara Lewis and Jane Merriman in London; Editing by John Picinich

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