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The Effects of High Oil Prices

Oil prices are currently near their highest level since the all-time high in mid 2008. In the past six months the cost of oil has jumped around 50%, but what does this mean for the financial markets?

Since the BP oil disaster in mid 2010, oil prices have been steadily on the rise. In the past few weeks, however, the unrest in the Middle East and North Africa (MENA) has caused oil to spike further, with Brent Crude hitting $120 per barrel at the end of February.

The price has dropped a little recently, but Brent is still well over $100 a barrel, and the geopolitical concerns that caused the recent spike have not gone away. It should also be remembered that Brent Crude peaked at $147 in mid 2008, so a further rise is not unprecedented.

Even if the situation in MENA eases, demand from emerging nations such as China, Brazil and India is currently putting upward pressure on prices. 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 continues, prices are only likely to go one way.

If oil prices are indeed set to stay at such amplified levels, or even increase to $120 a barrel and beyond, what will be the effect on the markets?

Gold and precious metals

In times of crisis, gold and precious metals are safe havens, and the markets have had their fair share of uncertainty recently. In addition to this, high oil prices are putting increasing pressure on inflation, both in the UK and in the oil-hungry economies of China and Brazil. Rising inflation in these markets is likely to drive investors towards precious metals as a hedge, pushing gold and silver higher in particular.

UK stocks

Prior to the recent downturn in equities due to the terrible events in Japan, the FTSE^® 100 was actually performing well despite oil concerns. While expensive oil hurts the travel and airline sectors, it has been broadly beneficial to those companies dependent on commodity prices, such as miners and oil explorers.

This is with oil prices at their current levels, however. If the price of the black gold continues its rise, profit margins are likely to be squeezed for all firms that use fuel (which includes the vast majority of FTSE^® 100 companies). As profit margins are eroded, analysts may start downgrading stocks. This in turn may prompt investors to pull out, with the FTSE^® 100 suffering as a result. Retailers are likely to be the worst affected, as household incomes come under pressure and consumer spending drops.

Sterling

The Bank of England has been under considerable pressure recently to combat inflation by raising interest rates. With oil prices pushing inflation higher, a bank rate hike in the near term would seem likely, so boosting sterling.

However, BoE governor Mervyn King has been very vocal about not wanting to damage the recovering UK economy by raising rates too early. With the most recent indicator confirming a decline in UK GDP, and with euro contagion, conflict in MENA and the events in Japan also potentially limiting domestic growth, an imminent hike is by no means certain. In fact, some kind of rate rise has probably already been factored into the markets, and so further delays may end up hurting sterling. An increase in oil prices is also likely to widen the gap between domestic wage growth and inflation, so pushing the pound lower.

Oil could fall

It is important to note here that oil’s elevated price is not guaranteed – it could drop in value as well. Prior to the MENA crisis, a glut in oil inventories in the US was suppressing prices. If we have an adequate supply and no significant increase in demand, there is no reason for prices to continue to rise. And if global economic growth is not as robust as expected, then the resulting decrease in demand may well mean oil will fall.

It may not be in the interests of OPEC (the Organisation of the Petroleum Exporting Countries) for oil to spiral higher. OPEC, in general, tries to keep prices broadly stable, as any dramatic spike could lead to world governments ramping up their search for alternative sources of fuel. Any sustained price increase will likely be met with a mitigating increase in oil production.

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

Take a position

Will a further rise in the price of oil take gold even higher? Or will the cost of black gold drop, providing respite to the travel sector? At IG Index you can spread bet on a variety of commodities, including Brent Crude and US Light Crude, providing you with instant access to global oil markets. We also offer bets on a wide range of stock indices, forex and over 7000 individual shares.

Updated: 24/03/2011