Why oil is important when it comes to picking an income fund

When Goldman Sachs speaks, markets listen. So when the giant US investment bank last month suggested a worst-case scenario could see oil hit $20 a barrel in 2016, the result was quite a flap, even if this was not Goldman’s base case. Bears got excited as they warned of economic weakness and the risk of a new deflationary downturn. Bulls shrugged, claiming Goldman has form in the area, having shouted about $200 oil back in 2007, just before the price of the black stuff collapsed.

Predicting the price of crude oil remains almost impossible

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Predicting the price of crude is a thankless task, especially as the normal rules of economics – supply and demand – have to be assessed with a geopolitical overlay. Supply can be tracked, demand can be estimated but politics remains the wild card. For the moment, OPEC and Saudi Arabia seem willing to force prices lower in an attempt to hammer America’s shale industry by rendering its surging supply uneconomic. Even Riyadh cannot afford this forever so a war of nerves – and cash reserves – is now upon us, with the added complication that any outbreak of cross-border conflict in the Middle East could create a spike at any time.

Indeed European Brent crude and its American equivalent, West Texas Intermediate (WTI) have both risen since Russia began to intervene directly in Syria, via air strikes. Few clients and advisers are likely to want to take a view on oil itself, via an exchange-traded commodity (ETC) instrument, although there is no shortage of choice here. However, many will be looking for income and here oil may have a huge role to play in the rest of this year and beyond.

Analysis of data provided by Morningstar shows that of the top ten performing UK Equity Income funds on a five-year view, just three have BP or Royal Dutch Shell in their top-ten holdings list. Their aggregate weighting toward energy stocks overall, as measured by funds under management, is just 4.0%. Three have a zero weighting. This suggests their performance has been boosted by minimal exposure to big oil and the big question facing these fund managers in 2016 is whether to increase their weightings or not.

Intriguingly, the highest-yielding UK Equity Income funds also have a relatively low exposure to the oil stocks. Again, analysis of data provided by Morningstar shows that of the top ten UK Equity Income funds as measured by dividend yield, just three own BP or Royal Dutch Shell. One has no exposure to oil at all, although the aggregate weighting is a little higher at 6.6%.

The UK’s leading income funds seem wary of oil exposure

Source: Morningstar

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It may not therefore take much to create a squeeze if income hunters do start to warm to oil stocks in the year ahead, either in the view the commodity priced has bottomed or management teams’ remedial action on costs, capital expenditure and balance sheets means their current juicy dividend yields are sustainable over the longer term.

Russ Mould

AJ Bell Investment Director