How high oil prices affect your stock picks

You will have noticed that oil prices are going through the roof. This not only affects you directly, in the form of higher prices at the petrol pump, but it also has implications for your stock market selections. These are, in a nutshell, that you should continue to hold energy stocks and steer clear of mass market general retailers. I explain why below. But first, let's look at the background to the current boom in energy prices.

You may recall that one of my core predictions at the start of this year was that the days of cheap oil are behind us. As oil flirts with the $70 a barrel mark this is now a reality. The boom in energy prices reflects the inherent cyclical nature of commodity markets and oil is no exception.

The low oil prices that persisted from the mid-1980s prompted serious under-investment in the long-term infrastructure for oil exploration, production, shipping and refining. Oil tanker capacity peaked in the late 1970s, while refining capacity and oil rig numbers reached maximum levels in 1981. As such, oil producers have been unable to lift output in the face of a massive injection of demand from China, India and the US in the last six years. Oil prices have had to move higher.

Indeed, higher demand has been the main driving force pushing oil prices from the low teens in 1999 to $60 this year. The tight market conditions, moreover, make the oil price very susceptible to supply disruptions.

So it is no surprise that the devastating impact of Hurricane Katrina has caused pandemonium in the oil markets.

No way back for cheap oil

The hurricane has left nine refineries in the Gulf of Mexico idle and four operating at reduced rates, cutting US refinery capacity by an eighth. Also, around 90% of the Gulf of Mexico's crude oil and natural gas output has been shut down. The supply disruption is most keenly felt in the US gasoline (petrol) market, with prices rising by an unprecedented 33% in just a week to record levels of $2.90 per gallon.

So are these prices unsustainable? In the near term the only prospect of oil prices coming off sharply is if prices move so high as to choke off demand. Even at US retail prices of $3 a gallon (up from $2 in April this year) it seems unlikely that the American's love affair with gas-guzzling sports utility vehicles will be compromised. Most analysts believe that gasoline prices will have to exceed $4 or even reach $5 a gallon before Americans will seek more fuel efficient modes of transport.

So in the short term energy prices will only drift back when the damaged refinery and production capacity is fully operational. But in the medium term high oil prices are here to stay.

Stick with energy stocks; ditch high street retailers

The rise in oil prices is bad news for the inflation outlook at home. In July the Bank of England's target measure of inflation (the consumer prices index) was 2.3%. This was higher than both the markets and Bank of England expected. As recently as February the Bank of England estimated that there was no chance' of inflation averaging more than 2.5% between July and September, and only a 10% chance it would exceed 2%. And more disappointment lies ahead in the next couple of months...

Still higher prices of oil will push up further the prices of fuels and lubricants' and passenger transport by road and air'. Higher oil prices will affect a host of other goods. It takes one cup of crude oil, for example, to make the plastic for a single disposable nappy! Meanwhile, electricity and gas prices are going up by between 7% and 15% in August and September. All things considered, the inflation rate this September could be as high as 2.8%. This will be enough to douse any near-term hopes of a further interest rate cut.

Against this background, stock selection is straightforward. Continue to hold energy related stocks. At the same time, with consumer confidence dented by fading interest rate cut hopes and disposable income diverted to paying mounting household energy bills and filling up the car, there will be less scope for discretionary spending on the high street. So steer clear of mass market general retailers.

By Brian Durrant, Investment Director of The Fleet Street Letter.