The pipes may leak but profits haven't dried up in the oil sector

For some, soaring prices are a reason to pile in; for others, it's time to look further afield

We all feel the effects of rising oil prices. Pull up at a garage forecourt today and you can expect to pay at least £1 for every litre of petrol - up from roughly 83p 18 months ago on the back of spiralling production costs and supply problems. Our household energy bills have been similarly affected. And for the many who spend great chunks of their income on such essentials, the discomfort is likely to get worse.

The oil giant BP revealed last week that leaks from corroded pipes had forced it to close its Prudhoe Bay oilfield in Alaska. Thanks to the laws of supply and demand, the price of oil was pushed even higher, to hit $78 (£40) per barrel on Tuesday. The resulting rise in forecourt fuel prices is a matter of when, not if.

BP's problems at Prudhoe Bay come against a background of conflict in the Middle East, where much of the world's oil is produced. It's no wonder that City analysts predict high prices are here to stay.

Yet amid the turmoil, investors in the oil industry are still making a profit. Higher oil prices lead, naturally, to more money being paid to oil companies such as BP and Royal Dutch Shell by their customers. This in turn attracts investment, pushing up share prices and leading to juicy dividends for investors.

BP is the biggest company on the London Stock Exchange, with Shell not far behind it. There are also listed oil-exploration companies, such as Cairn Energy and Burren Energy.

Overall, oil companies make up 16.7 per cent of the market capitalisation, or value, of the FTSE-All Share index. Their size means they dominate UK tracker funds. For example, last week, M&G's Index Tracker fund, which tracks the FTSE All-Share, had - as its name demands - 16.7 per cent of its money invested in oil stocks, in line with these companies' weighting on the index.

But the effect of rising oil prices is even more pronounced elsewhere. M&G offers "actively managed" funds run by managers who try to produce high returns by seeking out top-performing companies. The importance of the UK oil industry is reflected here: the M&G Recovery fund has ploughed 19.2 per cent of customers' money into oil stocks, and the M&G UK Growth fund 18 per cent.

Despite the vicious slump earlier this year, where fears about US growth sparked a general sell-off that wiped nearly 300 points off the FTSE 100, the oil sector continues to perform strongly, bolstering many funds.

Ultimately, how well the shares in a fund fare depends on whether the oil price remains high. Many fund managers believe that City analysts have yet to factor the anticipated long-term high price of oil into their all-important valuations of companies in the sector. Investors use these to determine whether a stock is worth investing in - ie, if it is cheap or expensive in relation to the earnings it could make.

Some analysts are now making their valuations on the basis of oil prices at $40 a barrel. So if the cost of a barrel of oil does stay as high as $70, then the oil companies will need to be revalued. In other words, oil companies may have been valued too cheaply and there could be scope for further share price rises.

It's not just individual funds bought by investors that benefit from a high oil price. Our pension funds rely on share price growth, dividends and interest from key companies such as BP and Shell.

However, a vastly inflated oil price has economic downsides - and not just in terms of higher petrol prices and household fuel bills.

"Oil prices can reach such a level - as being seen now - [where they] slow economic growth," says Gerard Lane, an investment strategist at the insurer Norwich Union. "If companies and individuals are paying more for energy, this diverts spending from other areas of the economy."

Rising oil prices have made alternative sources of energy, such as wind or solar power, look viable, both for commercial backers and individual investors.

There are a handful of dedicated alternative energy funds available but Mark Dampier, head of research at the independent financial adviser (IFA) Hargreaves Lansdown, warns that this is a high-risk area.

"You are investing in very small, technology-type companies," he says. "There is potential to make a lot of money, but there is also scope to make big losses."

No more than 5 per cent of an investment portfolio should be dedicated to this sector, he adds.

Darius McDermott of IFA Chelsea Financial Services recommends F&C Stewardship International. Its holdings include companies offering "geothermal" underground heating systems, and the car manufacturer Toyota, which makes the Prius, the petrol-electric hybrid car.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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