Oil Prices Rise Dramatically
While UK motorists are already feeling the effects of rising petrol costs at the pump, analysts believe the price of crude oil may well be heading for a return to triple digits. We examine the factors that are driving the latest rally in the price of crude and discuss the implications for the FTSE.
The relationship between economic recovery and the price of oil is extremely delicately balanced.
Oil prices will tend to increase as the world economy grows out of recession; large developing nations such as China, as well as established industrial giants like the US, will continue to create demand as their jump-started economies begin to roar into action once again. For example, China’s demand for oil in January this year jumped 28% compared with the same period last year.
On the other hand, if the price of oil increases too rapidly, inflationary shockwaves may be felt throughout the economy, forcing central banks to raise interest rates, thereby dampening the recovery, reducing demand for oil and driving down prices. This is especially true in the UK, where a weak sterling is magnifying the effects of higher oil costs and could eventually force the Bank of England’s hand.
How likely are triple digit prices?
In answering this question, it is worth noting the recent history of crude oil prices. After the record-high of $147 a barrel in July 2008, prices fell to a low of $32 a barrel in December of the same year. By contrast, during the past eight months we have seen a fairly narrow trading range, with oil prices fluctuating between $70 and $80 a barrel.
However, during the first week of April oil has climbed to $87 a barrel, the highest level since October 2008, leading to speculation that prices are heading towards triple digits. Morgan Stanley has set $100 as an early target, while Goldman Sachs has forecast an even more bullish $110 a barrel.
The more bearish perspective is that oil prices may be pegged back by suggestions that the economic recovery is still far from a sure deal. For example, analysts point to concerns over Greek debt levels, which have so far destabilised the euro, as a sign that we are still in the early stages of a recovery. Adding to this hesitancy are fears that fundamental levels of supply and demand are still stacked against rising prices, with the Opec oil cartel said to have excess supply of six million barrels a day.
The impact on equities
Generally speaking, higher oil prices tend to hit corporate earnings by driving up costs and can therefore be expected to dent the net value of major stock indices. And with the FTSE recently reaching a 21-month peak of 5780, the market may be susceptible to the effects of more expensive oil.
Then again, the FTSE contains a heavyweight faction of oil majors; BP, BG Group, Royal Dutch Shell and Cairn Energy are all likely to benefit from increased oil prices. And as commodities tend to rally in unison, another of the FTSE’s largest sectors, mining firms, could also benefit. Increased earnings for the likes of Rio Tinto, Xstrata and Anglo American would certainly help the FTSE to remain on an upward trajectory.
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Updated: 06/04/10