Why Britain should learn to stop worrying about oil

America’s Department of Energy recently forecast the price of West Texas Intermediate crude oil to average $48.70 a barrel for the first quarter of the year, $13 higher than the average for the same period last year. In spite of this, the price of the US benchmark crude, as well as Brent crude, has hovered around the mid-$50 price range for most of March.

Strong industrial demand from China, Asia and America is the main driver of rising demand, according to Richard Batty, global investment strategist at Standard Life Investments. “Supply disruptions in Iraq, Venezuela and Nigeria, as well as the strike in Norway, have led to oil prices being pushed around quite aggressively,” he says. The Northern hemisphere also experienced an extended bout of cold weather in early 2005, putting pressure on inventories when they were already low.

It is obvious why the American market is so worried about further oil price hikes: America boasts a much larger manufacturing base than Britain and accounted for 25% of global oil consumption in 2004 compared with EU consumption of 18%, according to a recent BP report.

However, many argue that a rise in the price of oil should be less of a concern for Britain today, as the country is less dependent on oil compared with 20 years ago. “The effect of a high oil price on the UK is limited because we use less oil to produce a unit of GDP, compared with the gas-guzzling US,” says Steven Bell, global chief economist at DWS Investments.

Britain’s industrial energy consumption has dropped from the equivalent of 48 million tonnes of oil in 1980 to 34 million tonnes today, according to Department of Trade and Industry figures. On the other hand, American industrial energy consumption is largely unchanged, says America’s Energy Information Administration.

America and Germany in particular are also sensitive to rising oil prices in winter because of their dependence on heating oil, says Bell. Britain is less so, as it uses gas and electricity for heating. Aside from industrial production, Bell adds that “in the UK, we are curiously insulated against the oil price at the consumer level”. One of the main reasons for this, he says, is the recent strength of sterling against the dollar, which was trading at $1.89 to the pound last week. Also, the rising price of crude is not reflected in the price of unleaded petrol in Britain because of the government’s freeze on petrol duty.

“The UK is experiencing a shift in economy, but it is not due to the oil price,” says Bell. “Companies that use oil, such as airlines, are suffering, but this is not a factor in Britain’s economic slowdown, as it is happening anyway.” Instead, he attributes Britain’s slowdown to other factors, primarily a weakening housing market.

Morgan Stanley chief US economist Richard Berner says the jump in the oil price can be attributed largely to the poor performance of the dollar. The weak dollar has meant commodity prices have risen when expressed in the American currency, he says. It is not just global fundamentals that are pushing up oil prices in dollar terms. The fact that oil is priced in dollars has helped those countries with appreciating currencies, including Britain, to benefit from cheaper commodity prices overall, he adds.

Batty says Britain can also benefit from the higher oil price because of the market’s relatively high concentration of utility companies. “The UK is a relative beneficiary because of the larger weighting of oil stocks. The high price of oil has much less of a negative impact here,” he says.

In real terms, today’s oil price, which recently hit a 20-year high, is lower than in many previous periods, says Batty. Because of inflation, the price of crude in 2005 would have to climb to $100 a barrel – about twice its current level – to be as high in real terms as the $40 a barrel in 1980.

In spite of this, it seems the British market is not insulated from rising oil prices. Corporate earnings in Britain appear to be falling, aided in part by oil. “Earnings estimates have been cut for most sectors, except energy and materials,” says Bell at DWS.

Jeremy Smith, manager of the Schroder UK Large Companies fund, calls the FTSE All-Share index “two-tiered”, as oil and mining companies are strong, while the rest of the market remains static.

The problem lies mainly with the many companies that rely on petroleum products for production. Todd Warren, an analyst at First State Investments, says that any company that is subject to oil as an import cost is having to raise its cost base.

“In terms of the stockmarket average, a $10 rise in the oil price, if sustained over a year, would hit corporate earnings by 1-3%,” says SLI’s Batty.

Smith says that for fund managers, the fact that oil companies currently make up more than 13% of the FTSE All-Share index has meant managers have to decide where to position their portfolios against the sector: “Most people are neither bullish nor bearish on the sector, but take different positions around BP and Shell.”

No one is quite sure where the price of oil is heading, given that if prices stay high, Opec is ready to approve an increase in output of half a million barrels a day. Observers of the industry, however, question the reality of oil priced at $55 a barrel.

Batty estimates that as much as $10-15 of the price of crude could be speculative. Hedge funds have pushed prices higher and the current level does not truly reflect fundamentals, he adds. Speculative interest, as well as better balance between supply and demand, have led many economists to predict that the price of oil will drop in the next few months.