However, in inflation-adjusted terms, the price of oil is still below its record peak hit in the early 1980's during the Iran-Iraq war. We have identified three short-term factors for this sudden spike in oil prices.

The Sudden Spike In Oil Prices
Firstly, the weak US Dollar has sunk to new lows against the Euro after breaching the 1.43 level. Since the rate cuts by the Federal Reserve on 18 September 2007, it has lost about 2.3% against the Euro and 8.4% year-to-date (as at 23 October 2007).

When the dollar is so weak, countries in the OPEC bloc may have priced oil higher in dollar terms to compensate them for the loss in the value of the dollar. A low dollar value depresses the purchasing power of the barrels of oil, once the sale of oil is converted into different currencies to pay for their respective imports.

Secondly, geopolitical factors may have been another reason for oil prices to increase. Tensions between Turkey and Kurdish rebels in northern Iraq, a net oil-exporting country, have created fears that supplies may be disrupted should the situation deteriorate. Research has shown that oil prices have a positive correlation with geopolitical factors. The oil embargo by the Arabian nations in the early 1970s caused oil prices to increase by about 400% back then. We have seen the same scenario of rising oil prices during periods of increased geopolitical risk play-out in the Iran-Iraq war in the early 1980s, the Gulf War in the mid-90's and after the 9/11 attacks.

Thirdly, there has been speculation over oil prices in the financial markets. As oil prices have increased by about 28% since late August till mid-October, traders who had short positions on oil have been forced to scramble to reduce their losses, driving prices higher. New speculators betting on further dollar weakness, and thus expecting oil prices to be driven higher, may have contributed to this spike in oil prices.

Ultimately, oil as a commodity is subject to the forces of supply and demand. The confluence of factors as we approach the winter season in the Northern Hemisphere as well as worries over supplies may create a situation where oil prices remain persistently high in the short term, although prices have come off the psychological US$90 mark on profit-taking. At the time of writing, oil last traded at US$85.90 as at 23 October 2007.

What Do Persistently High Oil Prices Mean For Investors?
From Chart 2, we can see that the forecast global oil consumption is likely to increase by a further 50% in the next 23 years. Since oil consumption is on a visible uptrend and is seemingly growing at a much faster rate than oil supply, we think that oil prices will remain high in the long run. So, what do high oil prices mean for investors?

Firstly, there will be an effect on consumers. In a world that is currently addicted to oil, with the US being the biggest oil consumer at 20.7 million barrels per day (source: CIA Factbook, 2004), the effect of the rising cost of living from food, to clothing and transport will have an impact on the typical consumer.

A decrease in consumer confidence is likely, and with the increase in prices, spending will likely decline. This will have an impact on the earnings of companies in the medium term and share prices will tend to reflect the lower earnings growth potential of companies.

Secondly, we think that energy- and oil-related investments will continue to do well. Companies that are involved directly or indirectly in the upstream portion like exploration, extraction and shipping of oil should continue to make strong profits. Downstream-related businesses involved in activities such as the refining of oil will also be able to enjoy increased margins.

Investing into commodities should also continue to garner interest. In an inflationary environment, commodities tend to give the best returns, while fixed income investments fare the worst. Whether investing in soft commodities which are planted, like wheat or corn, or hard commodities which are mined, like nickel and copper, the commodity basket as a whole will tend to rise in tandem with its cost of production. Precious metals will also increase in price as a hedge against inflation. We have already seen prices of gold and platinum increase sharply in recent times.

In the medium-to-long term, investments in alternative energies may also prove to be a positive bet. Continued high oil prices will create opportunities for the development of 'substitutes'. In economics terms, a substitute good refers to a good which can replace another and governments are likely to spearhead initiatives to support the development of substitutes to reduce their dependence on oil. Investing in these companies or technologies may have great earnings growth potential.


Unattractive Investments When High Oil Prices Prevail
The risks will increase for various types of investments, including companies which are involved in the logistics or transportation businesses. Airline companies typically have to hedge their fuel costs by entering into forward contracts so as to provide estimates for their operational costs. However, with rising fuel prices, profits are expected to be hit even harder as fuel surcharges imposed on customers or hedging activities cannot completely mitigate the high costs of fuel. For instance, FedEx, a courier company, burned over US$3.5 billion worth of fuel in the course of its operations last year and it is expected that this figure will continue to rise.

Secondly, companies which are heavily involved in manufacturing would also be affected by higher oil prices. High oil prices will squeeze the margins of manufacturing companies as operational costs increase. Companies which are involved in using oil as raw materials to manufacture goods, such as plastics manufacturers, will be hit by a double whammy of higher operational costs as well as high raw material prices.

Thirdly, fixed income investments may not be as attractive. As mentioned previously, persistently high oil prices will lead to continued inflation in the economy. Inflation is the enemy of fixed income investments, as the yields from these investments may not be able to keep pace with the loss in purchasing power. In Singapore, where the recently reported inflation figure in September 2007 showed a year-on-year increase of 2.7%, fixed deposits that return 1.5% or less are actually loss-making in real terms.

We can expect a continued deterioration in the prices of bonds as investors shift their money to assets which act as a hedge against inflation, such as the precious metals, or into riskier assets which can offer positive rates of return after adjusting for inflation.


Cheap Oil No More
The era of cheap oil appears to be over. We can see from the WTI options market that virtually no institution or trader has positions on oil to be at US$30/barrel by December 2008. To put this in perspective, US$30 was the price of oil at the turn of the millennium in 2000, just 7 years ago.

However, this spike in prices does appear to be more financially driven, rather than fundamentally driven, and investors should not start reacting by selling off their investments in fear that economies will come to a standstill in the event that oil prices run up even higher.

Unless there is a concerted shift to reduce the dependence on oil, prices in the long run only look likely to be headed one way ? up. Oil consumption is forecast to increase at a steady pace all the way till 2030. There is an immense need for oil with the emergence of China and India as their huge populations and economies expand to become more significant members of the global economy. Consequently, their demands for energy are likely to push the general demand up for oil even further. Oil is also becoming more difficult to find and oil companies are increasingly having to drill in deeper and at more dangerous locations as existing oil wells start to dry up.

Copyright The Financial Times Limited 2007