By Lucy Raitano
LONDON (Reuters) -Oil prices are up around 16% so far this year near $90 a barrel, with supply worries high given escalating Middle East tensions and tit-for-tat attacks on energy infrastructure between Ukraine and Russia.
Investors are paying attention. After all, it was an energy price surge two years ago that helped drive inflation and interest rates higher on a scale not seen in decades.
The International Monetary Fund on Tuesday described an "adverse scenario" in which an escalation of conflict in the Middle East would lead to a 15% jump in oil prices and higher shipping costs that would hike global inflation by about 0.7 percentage points.
The tightness in oil supplies, and higher prices, has been underpinned by oil producing group OPEC and other big oil producers curbing their output.
Morgan Stanley (NYSE:MS) has lifted its third quarter Brent crude oil forecast by $4 per barrel to $94. With oil prices expected to stay high, we look at the fallout for world markets.
1/ INFLATION WATCH
After U.S. inflation came in higher than expected for a third straight month in March, the spectre of inflation staying higher has returned with bets on interest rate cuts scaled back sharply.
Softening energy prices have been a principal driver of lower inflation expectations recently. Higher oil prices are seen as a threat to this trend.
A key market gauge of long-term euro zone inflation expectations, which generally track oil, on Tuesday hit its highest since December at 2.39%. The European Central Bank has a 2% inflation target.
ECB chief Christine Lagarde said on Tuesday fresh turbulence in the Middle East had so far had little impact on commodity prices. Oil, while near recent highs, has eased a little this week.
Still, the ECB has said it is "very attentive" to the impact of oil, which can hurt economic growth and boost inflation.
Zurich Insurance Group chief markets strategist Guy Miller said economies can survive, and producers are reasonably happy, when oil is around $75-$95 a barrel.
"But were we to see this to break higher then, yes, that would be a concern both from a growth and inflation perspective," he said.
2/ GO ENERGY STOCKS
Energy stocks are a clear winner from higher oil prices. The S&P 500 oil index and European oil and gas stocks remain close to record highs.
U.S. oil stocks have jumped almost 13% so far this year, outperforming the broader S&P 500's 6% gain.
Ed Yardeni, founder of Yardeni Research, said a rise in Brent crude to $100 in coming weeks was a possibility, recommending an "overweight" position on energy stocks.
Oil was last above $100 in 2022. It briefly spiked to around $139 after Russia invaded Ukraine, its highest since 2008.
"I believe you have to overweight energy as at least a shock absorber in your portfolio in the event that oil prices continue to go higher," said Yardeni.
Barclays (LON:BARC) head of European equity strategy Emmanuel Cau has had an overweight position on Europe's energy stocks since October, saying the sector tends to perform well in inflationary and stagflationary environments.
In contrast, Nordea CIO Kasper Elmgreen said he was negative on energy stocks because the costs associated with an energy transition were not correctly priced yet.
"They (energy firms) are going to have to carry a much higher burden for the drive to net zero, and that’s not being reflected in the share price," said Elmgreen.
3/ ROBUST DOLLAR
2024 kicked off with expectations the dollar would decline as inflation weakens and allows the Federal Reserve to start cutting rates.
Instead, the greenback is up 4.7% this year as rate-cut bets are slashed.
Higher oil prices could feed dollar strength.
Bank of America (NYSE:BAC) said that while it remained negative on the dollar over the medium term, elevated oil prices meant the U.S. currency had "upside risks".
That exacerbates pressure on economies such as Japan battling currency weakness, keeping traders nervy over possible intervention to support a yen languishing at 34-year lows.
"The yen and the euro will see their terms of trade worsen as energy prices rise. This implies they will be weaker if energy prices rise," said Mizuho Corporate Bank senior economist Colin Asher.
4/ FRESH EM PAIN
Higher for longer oil prices will also sting many emerging market economies, such as India and Turkey, that are net oil importers.
India's rupee hit record lows against the dollar this week.
With oil priced in dollars, many importers are also exposed to higher prices caused by currency fluctuations.
Even in Nigeria, typically Africa's largest oil exporter, a plunging naira currency has hit government coffers due to capped gasoline pump prices and a lack of local oil refining.