Mark Lister: How to cut the risks from higher oil prices

Over the past several months oil prices have risen by more than half to today's level of about US$115 ($156) a barrel. A significant part of this rise has been because of tensions in the Middle East. Oil is a key input to just about everything and its supply and affordability is often a driver of economic conditions. The situation poses risks to the delicate recovery path the world is on, inflation expectations, as well as the consumer impact that comes from rising petrol costs.

Global energy consumption has nearly doubled since the 1973 oil crisis. In terms of the energy mix, oil still provides about a third of total primary energy consumption. Despite the implications for global warming and the environment, coal represents almost 30 per cent of total energy use. Natural gas follows, supplying about a quarter of the world's energy demands, and the contributions from hydropower and nuclear energy are relatively small.

The United States remains the largest consumer of oil, accounting for more than 20 per cent of world consumption. China is the world's second largest user, having overtaken Japan a few years back.

On the production side, the Middle East region contributes about 30 per cent of the world's oil, with Saudi Arabia the largest producer. More than 20 per cent comes from Europe, another 16 per cent from North America and the remainder from Africa, South America and Asia.

The US produces a little less than 10 per cent of the world's supply, so is very much a net consumer. It does, however, have strategic oil reserves, which it has only used a handful of times, the last being in 2005 after Hurricane Katrina.

There are hundreds of different grades of crude oil. The grades are mainly a reflection of different sulphur content and gravity.

Those with low sulphur content are defined as sweet and those with a higher sulphur content are called sour. The reference to sweet and sour relates to the early days of crude oil production, when the easiest way to judge the sulphur content of crude oil was by taste and smell.

Gravity measures the weight of the oil relative to water, and the higher the gravity, the lighter the compound. The highest quality crude oils are those with low sulphur content and a high gravity - therefore a sweet, light crude is preferable.

When most economists refer to oil prices, they generally mean either Brent crude oil or West Texas Intermediate (WTI). WTI is one of the best quality crude oils in the market and although Brent is not far behind, it is not as sweet or as light.

Brent is generally accepted to be the world oil pricing benchmark, and is used to price most internationally traded oil supplies. In the US, WTI is the benchmark. They have different prices but they trade similarly, with the better quality WTI normally slightly more expensive. At the moment WTI is cheaper, because of oversupply issues at the US storage hub in Cushing, Oklahoma.

In my view, most of the recent rise in oil prices is because of a strengthening global economy. When economies are strong people begin consuming and manufacturing operations ramp up production, which increases the demand for fuel, which sees oil prices rise. Generally, stable oil prices are a sign of a healthy economic outlook.

But at the moment, a reasonable proportion of the price spike can be attributed to concerns about possible disruption to production in the Middle East and distribution to the rest of the world.

Consumers see the impact of such prices at the petrol pump, as well as experiencing the flow-on effects of increasing prices as companies look to pass on their increased fuel costs.

These increases are coming at an unfortunate time for consumers, given that our currency has fallen after the Christchurch earthquake and as interest rates look set to remain at low levels for some time. As an exporter we often cheer a fall in the dollar, although when it comes to paying for goods we import, such as petrol, a weakening currency is somewhat over-rated.

Investors have concerns because of the potential for high oil prices to derail an already fragile recovery. Oil is a key component of almost every company's cost structure, and sustained high oil prices will impact profit margins and business sentiment. It would also put even more pressure on consumer spending, which is already weak.

If the "Libya premium" we are seeing in the oil price is sustained, global economic growth could be reduced by about 0.5 per cent this year (from our current estimate of about 4.3 per cent).

The risk of a more severe disruption, while not high, has also risen after recent events. The likelihood 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 per cent.

A shock of that nature would reduce global growth by a greater magnitude, probably shaving about 2 per cent 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.

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

Most forecasters expect oil prices to fall from current levels as tension dissipates in the Middle East, with most forecasts closer to US$100.

However, it is 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 companies globally that give exposure to energy demand and prices, as well as on the Australasian markets.

Companies 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, as the economics of increasing capacity or new production opportunities increases as it becomes clear prices will stay at high levels for longer.

Investors should also consider taking steps to insulate themselves from the flow-on effects that go with a significant increase in energy costs. The two most prevalent are high levels of inflation as costs are passed on to consumers and a reduction in disposable incomes leading to lower discretionary spending. This could mean ensuring portfolios include investments in companies that have high levels of pricing power, which can easily pass on increases in costs to their customers without seeing any real reduction in demand. Examples of these types of companies are supermarkets, utilities and infrastructure owners.

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

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.