Speculation vs. Fundamentals: the landscape for Crude Oil - Peter McGuire

The protracted nature of the commodities boom, and rising food and energy prices, has placed many market pundits at odds over the future direction of the global economy. One particular market is central to this debate: Crude Oil. This unfolding scenario, combined with the fallout from the sub-prime mortgage crisis has created significant fiscal policy formulation problems for central banks the world over. Given this, it is no surprise that the agenda for the G8 summit to be held in Japan in July is focussed on record Oil prices, inflation and the diminished global reserve currency, the US dollar.

According to the World Bank, we are in the midst of the worst US housing recession since the 1930s, and with losses of up to $390 billion from the credit crunch fallout, global growth is set to decrease to 2.7 per cent this year, down from 3.7 per cent in 2007.

With this uncertain economic backdrop, and with Crude Oil prices doubling over the past year (see chart), market participants are debating whether the fundamentals of supply and demand will support a continuing rise, or whether speculative activity is artificially and unsustainably driving this upward movement in Crude Oil prices. Goldman Sachs analysts Arjun Murti and Jeffrey Currie, have recently said that $200-250 US dollars per barrel is becoming a likely long term outcome, as what they term as a "superspike" may occur.

Source Bloomberg

However, despite strong Crude Oil demand from emerging economies such as India and China, booming prices have led many to believe that the unprecedented rise resembles a speculative bubble not unlike the landscape for technology and internet companies in the 1990s. Simply, that there may be an imminent bust.

When prices surged through $100 US dollars per barrel, there was sentiment amongst speculators that with the US economy entering recessionary terrain, a slow down from some countries within the Organisation for Economic Co-operation and Development (OECD), and a staggered removal of transport-fuel subsidies in some Asian nations, a cumulative price decline for Crude Oil may result. Dually, the rapid price hikes could not be explained solely by demand-supply fundamentals.

On the other hand, Oil prices are being supported by the burgeoning consumerism and urbanisation of emerging economies, placing significant pressure on the world’s energy sources. For example, with some 40 million new cars on the road each year globally, and an Asian infrastructure investment set to dramatically increase over the next 10 years, naturally we will see demand for fuel increasing.

Strong demand forms a key element of the long-term price upswing, however it does not account for some extreme short-term market volatility. For example Crude futures surged $10.75 a barrel over a 36 hour period on June 6, the biggest rise on record and the largest in percentage terms since 1996 which was attributed to a flurry of speculative investment activity.

The two-pronged nature of surging crude prices was captured by high profile investor and political activist, George Soros, when he delivered testimony before a US Senate Committee in early June: "The bubble is superimposed on an upward trend in Oil prices that has a strong foundation in reality," he said.

While the debate centred on where the key Crude Oil price drivers lie continues, investors cannot ignore the potential for falling demand if Oil prices continue to rise unabated. The role of the OPEC and that of individual nations regulating supply is every bit as fundamental as the potential for falling demand. This can occur for a few key reasons.

First, consumers, particularly in East Asia, India and the Middle East have been insulated to a degree against the full extent of the price rise due to government subsidies. This situation is not sustainable given the heights the Oil price is currently reaching, and if subsidies are scaled back, demand is set to fall.

Easing demand may also be experienced by countries such as China as the economic slowdown of their Western export markets takes flight. China has also been stockpiling fuel in anticipation of the Olympic Games in August and as the games come to a close, we may see a subsequent decrease in Oil imports.

There are many complex factors currently affecting the price of Crude Oil and with investment banks, hedge funds and speculative traders using commodities to offset some of the inflationary pressure, it is difficult at best to predict the price trajectory. There are conflicting views from market analysts and commentators as to the primary drivers, and where we will see the price heading in the mid-term; a consensus is certainly elusive at this point.

Investors should examine the cumulative impact of all elements affecting these markets, not look at any one driver in isolation. The volatile nature of Crude Oil markets is testament to the speculative drivers affecting market movements, but it is in collaboration with fundamental supply and demand that we can truly get a macro-economic perspective of Oil market dynamics and gain insight into the long term outlook.

Peter McGuire is Managing Director of leading warrants provider, Commodity Warrants Australia (CWA).

Peter is a regular commodities commentator on Bloomberg Television and CNBC and appears widely in the Australian financial press. For more information please visit www.cwa.net.au.

Out with the Old, in with the New - Julia Lee

If you are wondering which was the best sector to have had your money invested in over the last financial year there's no doubt that the commodities boom fuelled by China has provided the best returns in Australia. The energy sector has been the best performing with a return of 30%, followed by the materials sector with a performance of 19%.

Coal and iron ore were the best individual performers in the 07/08 financial year. The best performing company in the top 200 was a coal explorer called Felix Resources with a return of 325% followed by Fortescue Metals with a return of 245%. In fact, if we look at the top 5 performers, 4 are involved in coal and 1 in iron ore.

The bad news is that all the other sectors outside of resources posted a decline. That meant falls in consumer discretionary which was the worst performing sector with a return of -42%. Industrials were the second worst performing with a return of -37% followed by property, financials, utilities, information technology, consumer staples and then the telecom sector.

In fact, perhaps 2007/08 will be remembered as the year we should have shorted the market with the market falling 16%.

The Australian economy has enjoyed growth for more than 17 years. The big question is, will this bull run continue? It's only natural that our market moves in cycles together with the economy. With the Australian economy slowing down, it looks like company profits will be the ones to suffer.

Worst performing stock was Centro Properties with a decline of almost 100%. The lesson we learnt during the year was that high levels of debt are always risky in business. It's not a problem when the business is doing well but high levels of debt are most definitely one of the things that speed the pace downwards when the business does run into trouble.

So what's in store going into the New Year?

The problems in the credit markets are far from over. For investors, be aware that it's very difficult to borrow large sums of money at the moment. That's bad news for finance companies, investment banks and also companies looking to borrow. While central banks are trying to help the credit markets find their feet again, it will be several months before things start to calm down.

For savvy long term investors, these times can prove extremely profitable. Use the over-reactions in the market to pick up quality companies at bargain basement prices. The market moves up and down, it's the natural cycle of markets. If the aim is to buy low and sell high, then wouldn't it be a consideration to buy at the bottom of the cycle and sell at the top? Unfortunately, most people end up doing exactly the opposite. For a longer term investor, perhaps it's a case of accumulating at the lows and for the shorter term investor it could be that the answer may be cash.

I know what I'll be doing. For me as a long term investor, I know that what I do now may be the basis for my wealth over the next cycle or next 7-10 years. Be smart. Play it cool and make great business decisions.

Happy Investing!

Should you lock in your home loan at a fixed rate? - Lauren Newlands

The only direction interest rates have been moving in lately is up, so should you lock in your home loan at a fixed rate, or is it too late?

After you've decided on a property in which to invest and have satisfied all the borrowing criteria, the next big decision you have to make is whether to fix the interest rate on your loan.

A fixed loan with set repayments every month for the fixed interest period makes budgeting easier, however the increased flexibility of a variable loan might be more useful to you than predictability.

To choose the option best suited to you, ask yourself these questions:

How tight is your budget? Are you fairly flushed with cash to make the repayments or is this an exercise with no margin for error?

• Do you want to direct extra funds toward the investment?
  
  
• Is this a long-term investment or could you be in and out within five years?

Strapped for cash?

If you're stretching yourself to make this investment, then a fixed loan may be the safer option for you. Predicting the long-term movement of interest rates is nigh on impossible, but at the time of writing the short-term predictions were for at least one more rate rise before the end of the financial year. In addition to this, as the resources boom continues to push the national economy forward, the chances of rates falling in the short term are low.

By fixing your rate, you'll know exactly how much your repayments will be for the length of the fixed interest period. This allows you to plan your budget with certainty - very useful if you’re not flushed with cash.

Varying your options and your rate.

If, on the other hand, you have ample funds to service the debt and wish to inject extra capital into the loan with the option of redrawing this at a later date to reinvest elsewhere, perform maintenance or renovations, or just reclaim some of your capital, then a variable loan could suit your situation better.

The other situation in which holding a variable loan is more advantageous is if you intend to, or there's a strong chance you will, pay the loan out before any fixed interest period would have ended.

Finalising a loan within the first four years could incur an exit penalty in addition to any standard mortgage discharge fee the lender charges.

However, if you hold a fixed-term loan and either refinance or finalise the loan before the fixed period has elapsed you will also be liable for a "break cost".

The average life of a loan in Australia is less than five years so consider your situation carefully if you intend signing up for a lengthy fixed term.

Hedging your Bets

There's a third option. If you can't decide between a fixed or variable loan and want a bit of both then you can take advantage of a split facility and allocate a percentage of your loan to both fixed and variable rates.

Splitting your loan does guarantee that, regardless of what happens, you won't get it 100 per cent wrong.

You'll still need to work out how much of your loan will be allocated to each of the rate types. Once again your own budget and timeframe for the loan will dictate the correct percentages for you.

If you're completely undecided about how to split the debt, then just go with the good old 50/50 rule.

As interest rates increase amid rising property prices, many borrowers are feeling the pinch and can't afford to risk
further rate rises so are taking out the "insurance" of a fixed rate on their loans.

Australians have historically favoured variable rate loans, which puts us out of step with New Zealand and the United States. More than 85 per cent of home loans in New Zealand begin with a fixed interest period similar to
those in Australia, whereas in the US, where the great majority of loans are also fixed, the fixed period is often for the life of the loan.

Lenders in Australia and New Zealand don't currently offer mortgages that remain fixed for the life of the loan.

Certainly in Australia, where the majority of mortgages are still taken at a variable rate, it would appear that there is currently not the demand for this product type.

Currently in Australia we're seeing a trend toward fixing our loans. In the past three years the popularity of fixed loans has been steadily rising but in the past 18 months alone the proportion of fixed loans has nearly doubled. If this trend continues fixed loans will claim more than 30 per cent of the market share.

Lauren Newlands is a financial analyst with financial services research group CANNEX.

© Australian Property Investor magazine - www.apimagazine.com.au   Reproduced with permission.

SMSF Last Minute Checklist + Forward Planning for Next Year - Laura Menschik

There is only a short time to go before the end of the 2007/2008 financial year.

Here is a last minute checklist for Self Manager Super Fund (SMSF) trustees and members to consider:

Many ideas are also relevant to superannuation and tax planning in general, but they are well worth a mention and/or reminder.

1. Ensure contributions have been received and banked by 30th June.
   
   
   • Check on ability to contribute into super.
     
   • Ensure that contribution caps have not inadvertently been breached.
     
     • Aged based concessional contribution limits.
       
       • Under 50 years old = Maximum $50,000.
         
       • Aged 50 years or older = Maximum $100,000.
         
     • Non- concessional contribution limits.
       
       • Up to $150,000 per annum.
         
       • Up to $450,000 with 2 years brought forward for those under 65.
         
         
2. Ensure all super interests have been crystallized.
   
   
3. Ensure all members with pensions have received the minimum pension payments.
   
   
4. If appropriate, check to see that all Allocated Pensions have been converted to Account Based Pensions.
   
   
5. Ensure documentation of all investment activities in the past year.
   
   
   • Check in-house assets have not exceeded 5% rule.
     
   • Review and, if appropriate, revise investment strategy.
     
     
6. If setting up a new SMSF a bank account must be opened, after the required fund trust deed and trustee arrangements .
   
   

Forward plan for next financial year with the following considerations:

1. Consider your contributions for the year and how they will be funded (see 'last minute' checklist #1, above).
   
   
2. If you are turning 55/60 next income year, consider the benefits of a Transition To Retirement (TTR) strategy.
   
   
3. If you are turning 60 in the forthcoming year, and are in receipt of a TTR, consider delaying taking pension payments until after turning 60 to receive these tax free.
   
   
4. If you are turning 65 next financial year, next year may be your last opportunity to:
   
   
   • make contributions unless you meet the work test
     and/or
   • recontribute pension payments back into superannuation.

As with all aspects of your financial affairs, and especially in regards to SMSF's, ensure that you are not beaching any rules, plan accordingly and appropriately and always seek professional advice in areas for which you are uncertain or have less expertise.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
Visit the WLM Financial Group online wlm.com.au

5 Tax Tips to consider before the 30th of June

1. Defer Taxable Income
   
   
   • If appropriate delay income from the last quarter to the next financial year.
     
     
2. Offset Capital Gains against Capital Losses
   
   
   • If you have a capital gain in this financial year, review your other investments to see if it is worthwhile to realise a capital loss to offset that capital gain.
     
     
3. Income Protection
   
   
   • Income protection insurance purchased in this financial year can be claimed in this years tax return.
     
     
4. Maximise Medical Expenses
   
   
   • If your medical expenses total more than $1500 this financial year you are entitled to a rebate of 20c in the dollar for every dollar spent in excess of $1500. If you have exceeded this limit consider purchasing additional items to receive the benefit of the rebate.
     
     
5. Make a HECS-HELP Payment to get a 20% discount
   
   
   • If you are enrolling in a course and are eligible for HECS-HELP you may either:
     
     
     • Make a full upfront payment of your student contribution.
     • Pay part of your student contribution upfront and receive 20% discount on the payment amount where it totals $500 or more.

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