WITH energy prices on the rise following heightened geopolitical risks and tight global supplies of crude oil, increases in retail gas prices seem inevitable. This is very different to the start of 2014 when many alerted a real risk of a fall in the oil price.

The problems in Iraq have put the growth of Opec’s crude oil production at risk and caused prices to surge above $114, their highest level in nine months. Around 60% of the forecast growth in the oil producing cartel’s production capacity up until 2019 was expected to come from Iraq but there is now risk on the downside.

Iraq is Opec’s second largest producer after Saudi Arabia and produces more than 3m barrels per day. However Iraq is unlikely to hit its 2014 production targets after Sunni insurgents from the Islamic state of Iraq made further territorial gains over the Shia-led government in northern Iraq, having already taken the city of Mosul. For the time being, oil supplies are said not to be at risk because the fighting hasn’t spread South, home to three quarters of the country’s crude output.

What is more, oil majors Exxon-Mobil and BP have started evacuating staff from Iraq, and Royal Dutch Shell confirmed the company has a plan in place should the situation deteriorate.

Some say most of the bad news is now in the oil price however high oil prices act as a tax on economic activity. Healthcare, telecoms, food and beverages, and travel & leisure sectors are all negatively correlated to the oil price by more than 60%. Global retail is the sector most negatively correlated to an oil price spike. Short selling consumer cyclicals appears a possible strategy should the insurgents drive on and threaten Iraqi oil production. However, a more prudent approach would be to focus on quality stocks with strong profit margins that can withstand volatility. Ultimately, an oil price spike would be deflationary, leading to lower bond yields and higher flows into more defensive stocks that pay high dividends such as utilities.

This all comes at a time when the US Federal Reserve reduced its asset purchases by another $10bn to $35bn per month. With the stronger US numbers signalling the health of the economy, the Fed appears confident there is still spare capacity. As such, bank rates can stay low for a while longer with no signs of higher inflation kicking in. Despite this, the Fed reduced its growth forecast for 2014 to 2.2% from 2.9% and the Vix index, a measure of volatility on the S&P 500, fell to its lowest level since February 2007. At the same time, many US firms are still reluctant to spend cash on expanding and have focused on share buy backs and dividend payments which have risen to record levels in the first quarter of 2014.

Samantha Dolby

samantha.dolby@brewin.co.uk

Samantha Dolby is an Investment Manager at Brewin Dolphin and offers advice on a wide range of financial services to private clients, trusts, charities and pension funds.

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