Highlight | High Oil Prices

Oil prices have increased by nearly 50% since last September and are now near their highest level since the pinnacle of the economic crisis in 2008. But what does this mean for the financial markets?

Since the BP spill last summer, oil has been gradually on the rise. Recent unrest in the Middle East and North Africa (MENA) has emphasised this trend, with Brent Crude reaching $120 a barrel near the end of February.

Oil has eased a little in the past week or so, but Brent is still over $110 a barrel, and the supply worries that caused the recent spike have not yet dissipated. Also, Brent Crude managed to hit $147 in mid 2008, so a further push higher would not be unique.

Even if the MENA situation improves, demand from China, Brazil and India is currently putting upward pressure on prices. A recent report from the US Energy Information Administration estimates that crude oil consumption will grow by 1.5 million barrels per day in 2011, while oil production will only increase by 0.8 million. If this trend persists, then oil prices are likely to advance even further.

If oil prices are indeed set to remain at their current levels (or perhaps increase to $120 per barrel or more) how will the markets respond?

Precious metals and gold

In times of crisis, gold and precious metals are traditionally seen as safe havens. There has been a significant amount of uncertainty recently, both in geopolitical and market terms, and this has caused prices to rise. Furthermore, amplified oil prices have been putting increasing pressure on inflation – both domestically and in the oil-thirsty economies of Brazil and China. Mounting inflation in these markets is likely to push investors towards precious metals as a hedge, so driving gold and silver higher in particular.

FTSE^® 100

Oil supply concerns in the MENA region have not been as detrimental to the FTSE^® 100 as might be expected. High oil prices have negatively affected the travel and airline sectors, but companies linked to commodities, such as miners and oil explorers, have largely benefitted.

However, if the price of oil continues to push higher, all companies that use fuel to a significant degree (which includes most FTSE^® 100 constituents) are likely to find profit margins compressed. As margins are squeezed, analysts might begin to start downgrading stocks. This could, in turn, frighten investors out of equities, with the FTSE^® 100 suffering directly as a result. Retailers could potentially be the worst affected, as increased fuel costs put household incomes under pressure and consumer spending drops.

Sterling

Due to rising inflation, there have been calls recently for the Bank of England to raise interest rates. With inflation hitting 4.4% this week, a rate hike in the near term would appear likely, with the pound gaining as a result.

However, with UK GDP declining by 0.6% in the last quarter of 2010, BoE governor Mervyn King has been keen not to risk a double dip recession by raising rates too early. Geopolitical concerns such as the conflict in the MENA region, eurozone contagion, and the events in Japan could also potentially limit domestic growth, meaning an imminent rate increase is by no means assured. In fact, a rate rise of some sort has probably already been factored into the markets, and so additional delays could end up hurting sterling. Further growth in oil prices could also force the pound lower, by widening the gap between inflation and domestic wage growth.

Gains are not guaranteed

The current high price of oil is by no means guaranteed, however. A surplus of US oil inventories was holding prices back prior to the MENA crisis, and unless there is a significant increase in demand in the near future, there appears to be no reason for prices to continue to climb. Moreover, if global economic growth is not as healthy as predicted, then the ensuing decrease in demand could well result in a fall for oil.

OPEC (the Organisation of the Petroleum Exporting Countries) is also unlikely to want oil to spiral higher. OPEC generally tries to keep prices largely stable, as a large spike could lead to governments becoming more reliant on alternative fuel sources. Any sustained increase in price will likely be met with a mitigating rise in oil production.

Forex is likely to have a large influence on future oil prices as well. Since oil is expressed in dollar terms, a strengthening of the greenback would cause a corresponding weakness in oil. Finally, the situation in the MENA region is very much a wildcard. With any developments here unpredictable at best, a stabilisation of the region would very probably cause the price of oil to ease.

Take a position

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Updated: 24/03/2011