China Securities Co., Ltd.: Feasible Strategies for Allocating Oil Assets

China Securities Co., Ltd. published a research report stating that crude oil has three layers of allocation value: Macroeconomic allocation value. During times of unexpected inflation, particularly in periods of stagflation, crude oil assets can hedge risks in stock and bond allocations. Portfolio allocation value. Allocating to crude oil means sacrificing some returns during low inflation or recession phases in exchange for tail protection during stock and bond downturns. Since this is intended to hedge against tail risks, crude oil is not suitable for "buy and hold" strategies. Strategic allocation value. When the global supply of resources is being restructured, a systematic review of the allocation value of crude oil assets is needed. For a supply-heavy country like China, the allocation of crude oil assets is even more crucial. In terms of instruments, oil and gas stocks and ETFs, commodity-type QDIIs, crude oil futures, and derivatives correspond to different return structures. Investments in crude oil should not first assess oil price fluctuations, but should start from the risks that need to be hedged, and then work backward to determine the instruments, positions, and exit discipline, enabling crude oil to truly serve its role in portfolio insurance and energy security hedging. Key points from China Securities Co., Ltd. are as follows: The all-weather strategy faced challenges this year, bringing to light a topic that hasn't been widely discussed for over a decadehow to evaluate the value of commodities, especially oil and gas resources, within the asset allocation framework. Furthermore, if one engages in crude oil asset allocation, what strategy should be adopted? Traditionally, the market asserts that crude oil is not suitable for allocation due to long-term demand peaking, the development of alternative energy, and significant oil price volatility. However, this judgment overlooks crude oil's unique position in inflation formation, supply shocks, and energy security. Crude oil is not only a result of inflation but can also be a source of further inflation diffusion. Given its attributes, alongside the backdrop of a rising global inflation center and prolonged bear market in bonds among mainstream Western economies, it raises questions about how we should participate in crude oil allocation within an "anti-stagflation" trading context. The cyclical allocation value of crude oil assets is primarily reflected in hedging inflation risks, especially the risk of economic stagflation. The most significant characteristic of crude oil assets comes from their inflation properties. Since 1990, the year-on-year correlation coefficient between Brent crude oil and the U.S. CPI is approximately 0.516, with an inflation beta of about 11.98. When CPI is below 1%, oil prices average a year-on-year decline of 39.6%; when CPI is above 4%, oil prices average a year-on-year increase of 40.2%. Thus, from the macroeconomic cycle perspective, crude oil holds the most allocation value during periods of overheating and stagflation. During stagflation, the real annualized return of Brent crude oil is around 7.33%, while the real returns for the S&P 500, copper, and the U.S. dollar index are -3.33%, -6.84%, and -2.18%, respectively; in a recession phase, the real annualized return for crude oil is about -8.69%. Since 1990, during stagflation, the average annualized return for Brent crude oil has been approximately 7.33%, compared to -3.33% for the S&P 500, -6.84% for copper, and -2.18% for the dollar index, with bonds also achieving only modest positive returns. Stagflation is the macroeconomic state where traditional stock and bond portfolios are most likely to fail simultaneously, and it is also when the allocation value of crude oil is most concentrated. The portfolio allocation value of crude oil assets: it provides a risk smoothing factor that is relatively independent from traditional stocks and bonds. Allocating to crude oil is not for the purpose of increasing returns, but rather to diversify traditional tail risks. Lets look at a set of correlations: the correlation coefficients of Brent crude oil with the S&P 500 and the CSI 300 are approximately 0.138 and 0.111, respectively, while with the Bloomberg U.S. Aggregate Bond Index and the China Bond Total Wealth Index, they are -0.118 and -0.207; in a stagflation environment, the correlation with the China Bond Total Wealth Index further drops to -0.334. When a 10% allocation of crude oil is added to a 60/40 portfolio, the actual loss during stagflation narrows from -1.73% to -0.86%, but the return during recession shrinks from 5.17% to 3.71%. Ultimately, allocating to crude oil means sacrificing some returns during low inflation or recession phases in exchange for tail protection during stock and bond downturns. Given that the intent is to hedge tail risks, crude oil is not worth a long-term "buy and hold" strategy. Taking the Brent crude oil futures contracts as an example, the annualized return since 1988 is about 4.81%, with an annualized volatility of approximately 35.51%, and a Sharpe ratio of only 0.136; the historical maximum drawdown reached 83.74%, lasting a considerable amount of time. From the perspective of risk-return ratio alone, crude oil does not exhibit a clear advantage over equity assets. The reasonable weight of crude oil should not be inferred from its long-term returns or Sharpe ratios, but rather from the maximum losses that the portfolio can withstand in extreme conditions such as stagflation and geopolitical conflicts. The strategic allocation value of crude oil: it hedges against the global systemic reconstruction of supply and supplements China's economy and asset allocation. Although historical data proves that crude oil assets are more often used to hedge the tail risks associated with traditional stock and bond allocations, it can be objectively said that the significance of allocating crude oil is best expressed during stagflation. In fact, the allocation significance of crude oil goes far beyond just the risk hedge at the moment of price increase. Since crude oil is at the upstream of the global physical supply chain, the volatility of crude oil prices reflects the restructuring of the entire supply system, which also determines that once oil prices rise, it synchronously indicates an increase in the inflation center. Historical experience shows that the changes brought about by oil supply shocks have often not been about short-term prices, but rather long-term supply structures. After the first oil crisis in 1973, major economies established strategic oil reserve systems; the second oil crisis promoted the expansion of non-OPEC supply from regions like the North Sea and Alaska; the shale revolution changed the structure of U.S. energy trade; following the Russia-Ukraine conflict, Russian oil shifted to export to Asia, while Europe turned to imports from the U.S., the Middle East, and other regions. The common rule is that while short-term geopolitical premiums can dissipate, the costs of transportation, redundant capacity, and security reserves brought about by the reconfiguration of supply chains are usually difficult to restore to pre-shock levels. The economic characteristics of Chinas crude oil exposure and the balance sheets of its investors inherently possess a "crude oil short" trait, which is also the strategic significance of crude oil in Chinas asset allocation. By 2025, Chinas dependency on foreign sources for crude oil consumption is expected to be around 72.7%, with imports estimated at 11.55 million barrels per day; for every $10 increase in international oil prices, annual import costs will rise by approximately $42 billion. Since the assets of residents and institutions are primarily made up of domestic assets like RMB-denominated stocks, bonds, and real estate, Chinese investors are inherently exposed to the risk of rising oil prices, and allocating to crude oil or energy assets serves as a hedge against the latent "crude oil short." In terms of tool selection, oil and gas stocks and ETFs, commodity-type QDIIs, crude oil futures, and derivatives correspond to different return structures. Oil and gas stocks derive returns from the transmission of oil prices to corporate profits, valuation reassessment, and dividend cash flows, with a beta of about 0.07 to 0.21 relative to Brent crude oil, making them more suitable as long-term strategic positions; Commodity-type QDIIs obtain direct exposure to oil prices through overseas oil ETFs, ETCs, or futures, usually showing a correlation coefficient with the underlying oil price of 0.82 to 0.92, but must bear the risks of roll yield, exchange rates, QDII quotas, and on-market premiums; Crude oil futures provide the purest and most capital-efficient price exposure, suitable for professional institutions to engage in event trading, but carry higher risks related to leverage, margin requirements, liquidity, and tail risks. Overall, crude oil allocation should not first determine oil price increases or decreases, but rather focus on the risks that need to be hedged, working backward to determine the tools, positions, and exit discipline, allowing crude oil to effectively serve its role in portfolio insurance and energy security hedging. Risk Warning First, global economic growth may lead to crude oil demand falling short of expectations. If the economy enters a recession or if energy transitions, energy efficiency improvements, and the development of alternative energy occur faster than expected, crude oil demand could weaken; in this scenario, crude oil may not provide the same stable hedging function as bonds or gold. Second, supply recovery or changes in producing countries' policies may exceed expectations. If geopolitical risk premiums dissipate, producing countries increase output, or the rapid recovery of elastic supplies like U.S. shale oil occurs, oil prices may experience a significant downturn, resulting in a noticeable weakening of crude oil assets short-term hedging effectiveness. Third, term structures and roll yield losses may erode returns. The actual returns of commodity-type QDIIs and futures products depend not only on spot prices but also on contango or backwardation structures, roll rules, and trading costs; when in a contango state for long periods, even if oil prices remain steady, the net asset value of the products may continue to be dragged down. Fourth, there exists a basis risk between tools and target risks. Oil and gas stocks are simultaneously influenced by corporate profits, equity valuations, and systemic risks in A-shares; commodity-type QDIIs also face risks related to RMB exchange rates, QDII quotas, and on-market premium risks; SCs have to contend with additional factors such as RMB exchange rates, delivery oil types, and regional premiums in Asia, which may lead to actual returns diverging from international oil prices. Fifth, risks related to leverage, liquidity, and extreme volatility. The margin mechanism of crude oil futures can amplify both gains and losses, while geopolitical events may trigger volatile market movements; during periods of high volatility or liquidity contraction, investors may also encounter risks of additional margin calls, forced position reductions, and rising trading costs.