Oil is my choice of hedge fund

After the stellar recent performance of NASDAQ stocks and Chinese shares open to foreigners, it may seem churlish to pick a class of plodding stocks that seem to have got left behind.

Oil shares are my tip for future growth, and the fact that they start so far behind the pack is one advantage, the only way is up.

But let us return to fundamentals. World oil supplies are limited by installed production capacity, and investment in this capacity is not what it should be; indeed you only have to look at the old fashioned and poorly maintained equipment in places such as Iraq and Iran to realize that new investment is badly needed.

Indeed, some bold analysts have even suggested that Saudi Arabia is not investing enough to meet rising oil demand, with Saudi Aramco slated to offer 10 million barrels per day by 2010 when 14 million barrels per day would be required.

We can all quibble over this conclusion - and Aramco certainly did - but the general direction is clear: not enough oil is going to be available if demand takes off.

Now per capita consumption of oil in China is a tiny fraction of US consumption and it does not need much imagination to see what impact Chinese GDP growth is going to have on demand for oil. China has little oil of its own and is already a big customer for GCC oil.

So in the medium term it is not hard to see a scenario where oil prices rise and so does output and investment in the sector. Then whereas oil companies have been struggling to keep their huge profits growing in a 20-year bear market for commodities, the reverse may well be true for the next two decades.

The short term scenario is also excellent. Oil prices are at almost a 20-year high right now, and talk of prices coming down appears to be greatly exaggerated. As soon as stock markets realize this oil share prices are going to go up, and by a significant amount to reflect this greatly improved profit outlook.

What should you buy? Perhaps not oil services companies, although they will do well. The premium should surely be placed on those companies which have large oil reserves, the majors like BP, ExxonMobil, and even Shell whose present management difficulties should be seen as a buying opportunity.

It is not hard to imagine an oil price shock in the near future. Iraq may degenerate into a civil war, disrupting production. Or Venezuela could have another national strike. Or Nigeria could plunge into chaos. Indeed, all three events at the same time would have maximum impact.

And what is the potential downside of holding oil shares? They all pay a good dividend, a legacy of years of low capital growth for shareholders.

You could plausibly argue that in a recession situation, then the demand for oil would drop to a level that reduced oil prices to a level that the market could bare. Indeed, the business cycle should follow this pattern eventually.

However, today oil company shares are trading at modest earnings multiples and have been ignored in the market recovery. If the market goes up they should be dragged up too; if the market falls for reasons related to the oil price then oil shares will still go up. Oil is a great hedge fund right now.