Geo-political risk has been one of the most used phrases in financial markets over recent months as ongoing tensions between Russia and Ukraine and the escalating conflict in Iraq have been seen by many as reasons to take a cautious stance in their portfolios.
However, despite those potentially catastrophic macroeconomic headwinds, out-and-out safe havens such as gold bullion and crude oil have failed to spike.
While the gold price is up in 2014, the Brent crude spot price is down more than 10 per cent – in US dollar terms – according to data from FE Analytics, with most of those losses occurring over recent months when tensions have worsened.
At the time of writing, the price of Brent Crude Oil stands at $97.49 per barrel.
Performance of indices in 2014
Source: FE Analytics
However Menges, manager of the $122m Lombard Odier Global Energy fund, says the price of oil will start to rise.
Though he isn’t positioning his portfolio for a very strong oil price which could put pressure on the global economic recovery, he says investors shouldn’t get used to these relatively low levels.
“In terms of the oil price, we know why it fell because there was the combination of less worry and the slowdown in Europe and China, at the same time that some Libyan volumes came back to the market,” Menges said.
“However, we think that production will be cut by OPEC [Organisation of the Petroleum Exporting Countries] to protect the downside and that will mean the price will stay range bound; as long as we see North America continuing to provide the important barrels needed by the world.”
The manager says there have been enough factors that would have created a major oil crisis over recent years as there has been no growth in supply from the large majority of oil producing countries over recent years.
However, Menges says the US has stepped up to the plate, increasing production by 3 million barrels over the last three years.
He says this is very important for investors to understand, as it is the major reason why disaster has been averted.
“If we didn’t have that rise in oil production in North America, we would have a major oil crisis,” Menges said.
“In the meantime, we lost the barrels from Libya, Iran, Syria, we had volatile production from Yemen and we lost the barrels from South Sudan. This means that Saudi Arabia’s output is at an all-time high.”
“If you didn’t have the revolution in North America, the Saudis would not have been in a position to compensate the ‘missing’ political barrels and the rise in demand. Apart from North America, which is the solitary source of growth and supply, everywhere else in the world has been a story of delays and decline.”
He added: “It’s very important to note that it is just a nightmare outside of North America.”
Though he understands why many investors would think that tensions between Russia and the West over Ukraine and the Islamic State’s [IS’s] growing influence in Iraq would cause the price of oil to surge, he says immediate production hasn’t been affected.
Only 10 per cent of Iraq’s output has been affected and nothing has happened to Russia’s production, Menges says.
“IS, and even the Russian tensions, haven’t had any impact on the near-term production.”
“However, if you look at the forward curve of the oil price, you have had a very interesting move over the last six months. Although the spot price is down about 10 per cent since the start of the year, the longer part of the curve has moved up around 10 per cent.”
“So, what does that say? OK, near term there is no impact, but longer-term there is still worry embedded into the curve because Iraq was expected to produce two-thirds of the increased capacity for OPEC over the next decade and this kind of event is disruptive.”
He added: “Then there is Russia. If they cannot sustain their production profile because they can‘t access technology to drill the Arctic or the Bazhenov Formation, it’s also a worry. I think there are more worries embedded into the long-term part of the curve that we don’t really see because we only look at the spot part of the curve.”
The manager is also confident that OPEC, which acts a kind of central bank for the oil price, will regulate the market. He says that though it would struggle to rein in the price of oil if it spiked rapidly, it can provide a floor like it has done in the past.
“For us, they are protecting the downside for the oil price. Is the downside going to be at $90 or $95 a barrel? I don’t know, but we are not very far away from it. The Saudi’s need around $90 a barrel to balance their fiscal budget and other countries in the Arab world need even more than that.”
“The falling oil price has been the recognition that there has been no near-term impact on oil production, but there will be a floor and that is a reflection of the OPEC countries wanting to manage the market.”
Menges has managed the $122m Lombard Odier Global Energy fund, which is a Luxembourg-domiciled SICAV, since August 2012. According to FE Analytics, it has returned 36.75 per cent over that time, beating its benchmark – the MSCI World Energy index – by close to 10 percentage points.
The fund sits in the IMA Specialist sector, but it has outperformed a composite portfolio of all energy funds in the IMA universe by 9 percentage points since Menges has been at the helm.
Performance of fund vs composite portfolio and index since Aug 2012
Source: FE Analytics
The only energy funds to have beaten it over that time have been Guinness Alternative Energy, Pictet Clean Energy and BlackRock New Energy.
Menges’ major theme in his portfolio is the energy revolution in the US and, as a result, he holds 80 per cent of his portfolio in the North America.
Though the manager expects the oil price to rise from its current level, he isn’t building his portfolio for that outcome.
He says that in order to take advantage of the current range bound market, he is focusing on companies that are able to grow, expand their returns and create value for shareholders.
Lombard Odier Global Energy has an ongoing charges figure of 1.26 per cent.
