Oil prices in general have become stronger during the year on general concerns about tight world oil supplies, as well as concerns about the demand for oil products such as heating oil during the northern winter in the US. NYMEX Sweet Crude Oil futures prices reached a high of $37.80 (€42.91) a barrel during September, a post Gulf War high. North Sea Brent Oil futures prices also rose, from $31.72 a barrel at the end of August to $34.98 a barrel, on concerns of supply disruptions by Iraq in mid-September, before settling back to around $29.84 a barrel at the end of September.
An announcement by OPEC on September 10th to increase production by 800,000 barrels by the end of the month had no immediate effect on the oil price. This prompted US President Clinton to release 30 million barrels of oil from the Strategic Petroleum Reserve on September 25, which caused oil prices to fall substantially. So what is the effect of oil prices on economies and markets?
Higher oil prices tend to adversely affect equity markets, as markets perceive that employees will attempt to claw back loss of purchasing power through higher wages. Higher interest rates often result which, combined with commodity inflation, push up inflation indices. Analysts have raised concerns that the squeeze on real incomes from higher energy costs will cause global growth to peak and slow down next year.
Equity markets are most at risk when economies are operating well above trend. The reaction of central bankers will be interesting. The first key organisation to watch is the US Fed. Some US commentators have argued that this is an interesting test of the US "new economy". While traditional economic theory would argue that the US economy is at risk from an external commodity shock, to date there has been little lobbying for reduced taxation as we have seen in Europe. If this continued, this would be a positive for interest rates. US investors seem more concerned about the threat to earnings than about inflation, as bonds have out-performed equities for much of this year.
The clear conclusion is that higher oil prices should not have the same impact as previous cycles. Rising oil prices were a huge threat previously when they provoked a severe reaction from the Federal Reserve in the form of higher interest rates. The sensitivity of corporate profitability to rising fuel costs is less than most headlines currently suggest, as only a few industries are large consumers. The sectors that are affected are transport stocks and chemical companies as well as a minority of utilities. However, most airlines - for example RyanAir and Lufthansa - have a policy of hedging fuel costs, but a number of chemical companies such as BASF and Bayer will be adversely affected.
Oil companies are clear beneficiaries and higher oil prices had a positive affect on the first half year net earnings of a number of companies. These include BP Amoco ($5,543 million, up from $1,903 million 12 months previously) and Shell Transport ($6,546 million, up from $3,624 million). Irish companies benefited too, including: Tullow Oil (€1.56 million, up from €0.32 million); Cairn Energy (£18.3 million, up from £7.7 million); Premier Oil (£15.6 million, up from a loss of £4.6 million); Dana Exploration (£4.0 million, up from £0.6 million); Dragon Oil ($1.5 million, up from a loss of $3.1 million); Paladin Resources (£3.3 million, up from £0.2 million); and Emerald Energy (£0.045 million, up from a loss of £0.433 million).
Looking forward we expect oil prices to become weaker as the OPEC oil increases come online and oil moves through the supply chain to refineries, and refineries keep up full production. US President Clinton has already stated that he would like to see oil prices at around the low to mid- $20s.
However, the outlook for metal prices is more positive for the rest of this year. Gold prices are likely to remain in the $269-$277 per ounce range and the outlook platinum and palladium prices remain positive.
As a result, we suggest switching out of oil-producing stocks reliant on the oil price, into mining stocks. Metal prices should continue to firm due to the strong global economic conditions and shortages of stock inventories.
The lower oil prices will affect the future earnings of companies such as BP Amoco, Shell Transport, Cairn Energy, Premier Oil, Dragon Oil, Paladin Resources and Emerald Energy.
Companies such as Anglo American, Billiton, Rio Tinto and Navan Resources are leveraged to the base metal prices, and Arcon International and Ivernia West are leveraged to zinc prices and exploration success.
Ronan Reid is joint managing director at Dolmen Butler Briscoe stockbrokers.
