How to protect yourself from soaring petrol prices

Crisis in the Middle East has put the price of oil back in the news again. That's bad news for consumers facing the prospect of petrol at £1 a litre - but there are ways to protect yourself by taking advantage of soaring oil prices.

The latest round of conflict in the Middle East has put oil prices firmly back on the news agenda. The cost of a barrel of the black stuff hit a new record of more than $78 earlier this month - and many are concerned it could go much higher.

Neither Israel nor Lebanon are important in terms of oil production, but the concern is that the conflict will spread through the region. The Middle East accounts for about a third of global oil output, and two-thirds of untapped reserves. Iran alone holds about 12% of the world's oil, and about 25% of global oil production is transported via the Strait of Hormuz, which links the Persian Gulf to the Gulf of Oman. If the crisis escalated to the point where Iran blockaded the Strait, oil could easily spike through the $100 a barrel mark.

The rising price of oil: hurricanes and increased demand

But it's not just about the Middle East. On the other side of the world, the US is experiencing the hottest year since records began in 1895. That means increased demand for electricity to power air-conditioning units - but more importantly, it's also bad news when it comes to hurricanes.

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US weather forecasting group the National Oceanic and Atmosphere Administration (NOAA) expects at least nine hurricanes this year, with at least one very likely to make landfall in the US. Oil production in the Gulf is still recovering from last year's onslaught by Katrina and Rita. If another hurricane hits between now and the end of the storm season in October, even a peaceful resolution to the troubles in the Middle East won't prevent oil from soaring.

But even if hurricanes and war don't disrupt the oil supply, the main problem is very simple - supply can't keep up with demand. The world's appetite for oil just isn't falling, despite record prices. A recent report from the US Energy Information Administration showed that Americans used more gasoline (petrol) in June than in any other month this year. That's despite the fact that the price of filling a car - even after accounting for inflation - is close to the highest it's ever been. And with car sales in China soaring by nearly 50% in the first half of 2006, there are plenty of gas-guzzlers just waiting to take up the slack, even if US drivers start to cut back.

This is all bad news for consumers facing petrol at £1 a litre, fuel surcharges on airline tickets and double-digit hikes in their gas and electricity bills.

The rising price of oil: how to fight back

Fortunately, there are plenty of ways that investors can hedge against their rising cost of living - by taking advantage of the long-term bull market in oil.And because most analysts can still barely bring themselves to believe that high oil prices are here to stay, many of those opportunities are still coming relatively cheap.

Despite the recent record oil price, BP is trading well below its April high of more than £7 a share. The forward price/earnings ratio is barely in double digits, and the dividend yield is sitting at around 3%. That's very reasonable, when you consider that BP has ample room to double its annual payout if it so wished - the current dividend is more than three times covered by profits.

Rival Royal Dutch Shell also looks a good bet. It is trading at just nine times prospective earnings, and yields more than 4%. While Shell has the lowest conventional oil reserves of any oil major, it is also among the frontrunners when it comes to alternative sources of oil.

The company has ploughed money into Canada's Athabasca tar sands. These tar sands, covering an area larger than England in Canada's Alberta province, are thought to contain oil reserves equivalent to 1.7 trillion barrels. They haven't been developed in the past because it's expensive to get out of the ground - nearly $18 a barrel compared to as little as $2 for oil from the Middle East. But of course, that's not such a problem when oil is sitting at $70 a barrel.

The rising price of oil: look to alternatives

But it's not just oil companies you should be looking at. The soaring price of oil has made a variety of alternative energy sources viable. The more high-profile ones, like ethanol, have experienced an influx of investment.

Other less hyped sources could also prove of interest to smart investors. One of the main beneficiaries of the push for alternatives to oil could be one of the oldest fuels of all - coal.

There is enough coal in the US alone for at least another 250 years, at a time when there many experts fear that oil is running out. Both China and India are looking into 'clean' coal technologies - in fact, China's Shenhua coal mining group has just signed a deal with Shell to work on proposals for a plant that turns coal into oil, with an aim to start production by 2012.

Again, you don't have to look far to get exposure to the coal story. FTSE 100 mining giant, Xstrata, is the world's biggest exporter of coal for use in power plants. The group is also part owner of the world's largest open-pit coal mine, based in Colombia. And yet it's by no means expensive - Xstrata trades at a forward earnings multiple of less than nine.

When you can pick up major blue-chips in a growing sector at these kinds of prices, it seems almost a waste not to. And knowing you're holding them in your portfolio might help to take some of the sting out of paying the bill next time you fill your car.

First published on MSN Money (29/07/06)

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.