Crude Oil Allocation Key for Chinese Investors Amid Rising Inflation and Supply Shocks

Chinese investors are naturally exposed to the risk of rising oil prices, making it essential to allocate to crude oil or energy assets as a hedge against their implicit 'short crude oil' position. According to Zhitong Finance APP, China Securities Co., Ltd. released a research report stating that crude oil has threefold allocation value: macro allocation, portfolio allocation, and strategic allocation.

The macro allocation value of crude oil lies in its ability to hedge against inflation risks, particularly during stagflation phases. In fact, the correlation coefficient between the year-on-year change in Brent crude oil prices and the U.S. CPI has been 0.516 since 1990, with an inflation beta of approximately 11.98. When the CPI is below 1%, oil prices have fallen by an average of 39.6% year-on-year; when the CPI is above 4%, oil prices have risen by an average of 40.2% year-on-year.

The portfolio allocation value of crude oil assets lies in providing a risk-smoothing factor relatively independent of traditional equities and bonds. Allocating to crude oil involves sacrificing some returns during periods of low inflation or recession in exchange for tail protection when both stocks and bonds decline. Since the purpose is to hedge against tail risks, crude oil is not suitable for a long-term 'buy and hold' strategy.

The strategic allocation value of crude oil lies in hedging against global systemic supply restructuring and complementing the Chinese economy and asset allocation. As crude oil sits at the upstream end of the global physical supply chain, fluctuations in its prices reflect a restructuring of the entire supply system, which implies that any sustained rise in oil prices will concurrently push up the central tendency of inflation.