Using energy equities as a hedge against inflation, May 2017

With inflation now at 2.7%* and the Bank of England saying 2017 could be “a more challenging time for British Households” with inflation rising and real wages falling, Tim Guinness, co-manager of Guinness Global Energy fund has proposed energy equities as a good hedge against rising prices.

Nearing the end of the great deflation era

“Whilst we recognise the unpredictability of future inflation, we believe that the case that we are nearing the end of the great "deflation era" is growing. Interest rates look to have bottomed, quantitative easing has expanded the monetary base and the commodity cycle looks to have bottomed.

“With this in mind, there is increasing concern by some investors over the threat of inflation. 'Real assets' like property and commodities (particularly gold and crude oil) have historically delivered real long-term returns that have hedged against inflation. Moreover, energy equities have delivered substantially higher investment returns than those delivered by crude oil or crude oil futures. We propose energy equities as an advantaged, attractively-priced asset class that could offer very useful inflation-hedging characteristics.”

What can past inflationary periods tell us?

“Looking at two periods of time in the past and using a basket of energy equities (represented by an equally-weighted basket of Exxon, Chevron, Hess, Occidental, Murphy, Conoco, Marathon and BP until 1995, and by the MSCI World Energy Index after that time), we found that in the period 1987-2016:

• Energy equities delivered substantially higher annual returns (+9.7% p.a.) than either the crude oil price or crude oil futures (3.9% p.a. and 1.7% p.a. respectively)
• Energy equities delivered these returns with a lower volatility
• The total return generated from owning energy equities was substantially higher than those calculated from owning crude oil or crude oil futures, with energy equities up nearly 15x over the period versus crude oil at 4x and crude oil futures at 1.6x.

“We found a similar outcome for the 2000-2016 period, with energy equities delivering consistently higher correlations together with greater absolute levels of returns and lower volatility in monthly returns. While not published here, our analysis considered a number of time periods and we found that our basket of energy equities delivered better investment returns than either crude oil or crude oil futures over all the periods.

“We are aware that analysing a 30-year period could be considered on the short side. Unfortunately commodity futures data only exists back to 1987. However, we take comfort from some work carried out by GMO (September 2016) analysing the performance of energy and metals equities in periods of inflation since the mid 1920s. According to GMO, a basket of energy and metals equities kept up with or beat inflation in six out of eight occasions when US inflation was more than 5% for a period of one year or more. In fact, the commodity producers delivered real returns of more than 6% per year on average during these inflationary periods, as compared to a destruction of purchasing power of around 1.6% per year for the S&P 500.

Conclusion

“We conclude that energy equities have historically offered a good route for delivering oil price-related, inflation hedging investment returns with lower level of volatility. We believe that they should certainly be considered as part of a basket of 'real return' assets to hedge against future inflation.”