Asset Management

Understanding the jump in the price at the pump

Oil prices are going up, rising as high as $128 per barrel of Brent crude in recent weeks – higher than at any point since the summer of 2008, when the per-barrel price of oil rose to $147. The hike in prices comes as a bit of a surprise. We expected prices to moderate this year, given the economic slowdown in Europe, and the lower growth rate in China.

With oil prices on the rise, gas prices have shot upward – climbing about 30 cents in February alone. The increase has sparked calls for Washington to intervene, but because the prices are affected primarily by geopolitical events and financial speculators, the impact of any intervention is likely to be small. With the effects of higher gas prices rippling through the economy, and with oil prices likely to rise even more this summer, investors should closely monitor their portfolios: Higher oil prices benefit the energy sector, while the food, airline and auto industries are likely to be the hardest hit.

What’s driving prices higher?
There are a number of interrelated factors behind the rise in oil and gas prices. Uncertainty in the Middle East has been particularly important, given the possibility that Iran could be the target of a Western military campaign. Iran has contributed to the uncertainty with threats to block access to the Strait of Hormuz, which is the gateway for approximately 35% of seaborne oil and 20% of seaborne liquefied natural gas flow. There have also been output declines in a number of other politically troubled oil-producing nations, including South Sudan, Libya, Yemen, Venezuela and Syria.

Financial speculators also influence oil prices, generating an estimated 30% of all oil trading in commodity markets. We believe the heightened tensions with Iran led speculators to drive up oil prices. The price increases may be curtailed given that Iran has agreed to multilateral discussions about its nuclear program.

As those talks play out, prices remain high, which adds to the stress on the U.S. economy. According to Federal Reserve chairman Ben Bernanke, the high prices are “likely to push up inflation temporarily while reducing consumers' purchasing power.” The consumers feeling the biggest impact will be those at the lower end of the spectrum, as they have less slack in their consumption patterns.

There is already evidence of reduced gas consumption. During one week in late February, for example, consumption dropped 6.9%, the biggest year-on-year drop since October 2008, according to MasterCard Advisors LLC. This decline also comes at a time when U.S. demand for gas and other refined products recently fell to its lowest level since April 1997, according to the Energy Information Administration, reflecting reduced usage and greater use of fuel efficient vehicles.

Calls for action
With 2012 being an election year, there are calls for the federal government to initiate actions that will help to reduce gas prices. The reality is that not a lot can be done. A U.S. President is authorized to use the Strategic Petroleum Reserve, which is the world’s largest supply of crude oil, and maintained by the U.S. Department of Energy. The impact of doing so is often modest, however. The Obama administration tapped into the SPR last summer, after the upheavals in a number of oil-producing nations, selling 30 million barrels of oil. But gas prices only dropped by eight cents per gallon (and then quickly rose again). With gas prices often rising 20 cents per gallon in the summer months, reflecting higher demand, expect to hear even more calls from the political class for President Obama to “do something.”

We expect that the biggest factor in the future direction of oil prices will be geopolitical events. If war with Iran looks less likely, prices will fall. Conversely, if the multilateral talks break down, prices could shoot upward. Similarly, political volatility in any major oil-producing nations can also trigger price hikes.

Winners and losers
For investors trying to decipher the implications of higher oil and gas prices, one clear “winner” is the energy industry. Traditional oil producers make more money from higher oil prices, while there are also benefits for alternative energy, such as solar or geothermal, since the higher prices triggers greater interest in their products.

We believe those that will “lose” from higher oil prices will tend to be energy-intensive industries: food, autos, and airlines. The food industry faces higher production and transport costs, as does the auto industry (though the impact on the auto industry will be slightly offset by rising demand for fuel-efficient cars). For airlines, fuel costs were about 30% of total operating costs at this time last year. Today, fuel is about 40% of operating costs. With airlines already increasing fares to cope with the higher costs, we expect to see some decline in flying, which in turn will adversely impact the travel and tourism industry.

Given the potential for turbulence in the global oil market, now is an opportune time for investors to monitor their exposure to the oil sector – directly or indirectly – and analyze how it could impact their portfolio. This monitoring is even more important amid heightened geopolitical tensions and a U.S. presidential election in November.

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