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Why is the price of oil so high? Because demand is high and supply is low. Oil is a finite resource, but we don’t treat it as such. We rely on it to heat our homes, power cars and fly planes, and to make hundreds of products we use every day – plastics, cosmetics and nylon, for example. In recent years, demand has jumped as the emerging economies of Asia have upped consumption. But supply isn’t increasing at the same rate: very little has been spent on exploration over the last few decades. In recent months, the strengthening dollar has also had an effect on the price for the UK – oil is priced in dollars, so the stronger the dollar the more expensive oil is in pounds.
Will the oil price stay high?
Most likely. The demand/supply position isn’t changing, as even current explorations will take years before they can boost supply. But demand is soaring – mainly fuelled by Indian and Chinese growth. As countries industrialise and the population becomes wealthier, they use more oil. At present, China and India use approximately one seventh of the amount of oil per person that the industrialised world does. That won’t last. Note, for example, that car use is growing very fast in China. Many now believe that oil, along with other energy commodities, is in a secular bull market. These commodities may suffer the odd correction, but the main direction is up.
How does this affect the economy?
When the oil price rises, so does the cost of everything that uses it as an ingredient. And as costs rise, so corporate margins get hit. Last month, factory input prices in the UK rose by 2.1% – the fastest increase for 20 years – but output prices (what manufacturers charge at the factory gate) fell by 0.2%. This suggests firms have been absorbing much of the rise in oil and other commodity input prices themselves. This will soon be seen in the form of lower profits. Then, at some point, firms will need to deal with falling profitability, by passing their costs on to the consumer, causing retail inflation. The consumer price index in the UK is already at a seven-year high and there is evidence of rising inflation in the US. Even in advance of this generalised inflation, rising oil prices tend to hit consumer spending: the more you spend on petrol, the less you tend to spend on shoes. The problem is that, under these circumstances, the policy response becomes tricky: central banks want to cut rates to stimulate spending and growth, but the risk of inflation prevents them from doing so aggressively, if at all.
What price crisis?
In the 1970s, oil prices rocketed from $40 per barrel to $75, at which point the global economy stopped coping and started struggling with high inflation and low growth. Today, the industrialised world is less reliant on oil than it was 30 years ago. According to John Paul Rathbone on Breakingviews.com, it takes half the oil it used to to produce $1 worth of output. This gives us a starting point for trying to figure out what oil price would tip the global economy over the edge today: oil prices have to rise by twice as much as they did in the 1970s to have the same effect. Then they rose $35, so now they need to rise $70. Tack $70 onto the average oil price two years ago, and you get a tipping point of $100. This may seem a long way off, says Rathbone, but we also need to consider natural gas, which we use much more of than in the 1970s. The price of gas is rising fast – it is now at $107 per barrel of oil equivalent. Factor this in, and British energy users are already paying the equivalent of $75 per barrel of oil all in. It won’t take many hurricanes or political upsets in the world’s major oil-producing countries to move that to the $100 tipping point.
What should investors do?
Make sure they have some exposure to oil in their portfolios. The oil majors have already seen huge share-price increases, which means that further upside could be relatively limited in the shorter term. However, as Barron’s points out, the stockmarket has been slower to pick up on the potential in the oilfield-services companies, which have underperformed exploration and production companies significantly. For the last year or so, “the jury has been out” on the longevity of the oil-price rally, but now, with long-dated futures suggesting that crude-oil prices will remain at $55 into the next decade, “investors are starting to factor in sustained earnings growth from the service companies and drillers”. So for the stocks, it is catch up time: the average E&P stock has risen 150% since the start of 2003 but the average oil-services stock is up a mere 74%. In the US, analysts suggest industry blue chips such as Schlumberger, Baker Hughes and Haliburton, as well as deep-water drillers such as Transocean. In the UK, one smaller stock to look at, says The Times, is oil-services group Abbot, which trades on a relatively pricey 2006 p/e of 19 times. But given that it is firms like this that make oil production happen, the shares are “worth buying”.
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Annunziata Rees-Mogg
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