Oil Price Spikes – A Threat to Investors

Recent spikes in the price of oil have seen the price rise over fifty percent in the past several months. The current barrel is trading at around US $115.

This is concerning for investors because of the potential for high oil prices to further upset an already delicate recovery. Oil is a key component of almost every company’s cost structure, either direct or indirect, and sustained high oil prices will impact profit margins and business sentiment. It also threatens to put even more pressure on consumer spending, which is already weak.

We observe that if the current “Libya premium” we are seeing in the oil price is sustained, global economic growth could be reduced by about 0.5% this year (from our current estimate of approximately 4.3%).

There is a risk of a more severe disruption arising. However, the chance of tension escalating, and oil prices rising to US$150 a barrel (and staying there for a time) remains low, maybe at a probability of 10%.

An event of that nature would reduce global growth by a greater magnitude, probably shaving about 2% from our forecasts, and pushing the world back towards recession territory. The effects of such a shock on inflation could be somewhat greater than the effect on economic growth.

Those that will be hit the hardest will be those countries that are more dependent on imported oil. Countries that have significant domestic energy production would be insulated. Industrial countries would be better off than developing economies given their greater levels of energy efficiency.

The general consensus from forecasters is that oil prices will reduce from current levels as tension dissipates in the Middle East, with most forecasts closer to US$100.

Given the situation however, it is still important to recognise such risks and position portfolios accordingly. For investors looking to reduce some of the risks of rising oil prices, one strategy could be to own shares in oil producers that will benefit from rising earnings should oil prices remain elevated. There are a number of businesses internationally that give exposure to energy demand and prices, as well as on the Australasian markets.

Those enterprises that provide services to the oil sector, such as drilling and engineering operations, are also likely to see strong growth should oil prices remain high. This is due to the economics of increasing capacity or new production opportunities increasing as it becomes clear that prices will stay at high levels for longer.

Investors should also consider taking steps to protect themselves from the flow on effects that go hand in hand with a significant increase in energy costs. The two most prevalent being high levels of inflation as costs are passed on to consumers and a reduction in disposable incomes leading to lower discretionary spending. A strategy could be to ensure that portfolios include investments in companies that have high levels of pricing power, which can easily pass on rises in costs to their customers without seeing any real reduction in demand. What type of companies are these? Think of supermarkets, utilities, and infrastructure owners.

In order to protect against the risks of reduced consumer spending, investors would be wise to ensure that they are not over-exposed to those sectors that are dependent on discretionary and luxury spending, such as discretionary retail and tourism.

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