What do higher oil prices mean?

Written by Rebecca O'Connor on 29th September 2016

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At Good With Money, we’re not fans of investing in oil and gas and prefer our investments on the clean rather than the dirty side of the energy equation. Nevertheless, as Jason Hollands, managing director of Tilney Bestinvest, explains below, big shifts in the oil price have implications for all of us, even if our only investment is a workplace pension. Read on to understand the performance of your funds in light of OPEC’s new oil deal. 

Will the OPEC oil deal fuel inflation?

Last night saw OPEC, the oil cartel whose members account for around 40 per cent of global supply, confound sceptics by finally reaching an agreement for a modest cut in production for the first time in eight years.

In so doing this has the potential to bring to an end a prolonged phase of aggressive oversupply driven principally by Saudi determination to see off the threat posed by the US shale industry but which has been further complicated by the lifting of sanctions on its arch-foe Iran following its accord over its nuclear ambitions. In the Middle East, oil supply is equivalent to gun boat diplomacy and a weapon of political influence.

The OPEC announcement, which has been made possible by allowing Iran to be exempted from a production cap as it rebuilds its market share, has been greeted by an immediate sharp hike of 5.3% in oil futures on the New York exchange.

This should prove particularly positive for the UK stock market which has significant exposure to the oil and gas sectors (which accounted for 11.09% of the FTSE 100 at the end of August), with BP shares rising by 4.3% and Royal Dutch Shell shares by 5.5% in initial trading this morning.

The oil and gas sector is likely to return to its pre-eminent place as the largest sector in the index, eclipsing Personal & Household Goods. There are of course two sides to the story and casualties this morning have been airline stocks such as Easyjet ( -1.6%) and International Consolidated Airlines (-1.2%).

Cheap oil prices have also been a major factor, alongside anaemic global growth and manufacturing overcapacity emanating from China, behind very low levels of inflation across the globe which central banks have been struggling to reverse.

If the deal to reduce oil output holds and demand / supply continues to rebalance, it follows that this should feed through to higher inflation including rising prices at the petrol pumps.

Higher inflation at a time when government bond yields have evaporated as a result of Quantitative Easing programmes is certainly something investors need to be aware of (10-year Gilt yields are currently at 0.72%).

Sustained higher oil prices would also be good news for the US, easing pressure on the shale oil industry which has experienced a wave of brankruptcies. This should benefit the US high yield bond market which has significant exposure to oil related credits.

For regions that are major net importers of oil, such as Europe, Japan and India however a sustained move to higher energy prices will be less welcome – reducing what has in effect been an added form of stimulus, placing greater cash in the hands of consumers.

There are still a number of uncertainties around about whether the OPEC deal will stick as the detail on who will cut production quotas will only be agreed in November and cartels are notoriously unstable.

And then, of course, much depends on what non-OPEC members choose to do in terms of their own output. The proposed cut in OPEC output broadly offsets recent increases in supply from the likes of Iran, Nigeria and Russia.

So, while the oil price has nudged up and the market is going through some rebalancing, we don’t see any near term return to the levels last seen in 2014 and it may simply settle between $45 – $50, which is certainly above its lowest points but well below historic levels as the graph below shows.

Also of interest below is a graph which shows the close relationship between Consumer Price Inflation and Brent Crude over the past five years.

 

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