Oil: Where to from here?

Oil prices won't damage the global economy at their current levels, but an Iran-related price spike could.

PORTFOLIO POINT: Current oil prices are unlikely to derail the global recovery, but a rise to $US150 a barrel would pose a significant risk.

World oil prices are rising again. Since its low last October, US West Texas Intermediate is up 40% and Asian Tapis oil prices (which drive Australian petrol prices) are up 18%.

Last year, a similar surge in the oil price left global growth weak, and vulnerable to European and US debt scares in the September quarter. So what is the risk this time around?

What’s behind the latest surge in oil prices?

The latest surge in oil prices reflects three key developments. Firstly, we are seeing a long-term structural rise in oil demand in the emerging world on the back of rapid industrialisation in key countries, including China.

This likely has much further to go as annual oil consumption is just 2.5 barrels per person in China and just one barrel per person in India, compared to around 15 barrels per person in Australia and 24 in the US. So while oil demand growth is weak in developed countries – reflecting poor growth, energy efficiencies and the growth of alternatives – it remains strong in the emerging world (see the previous chart). As a result, the developing world now accounts for a greater share of world oil consumption than do developed countries.

As the Peak Oil crowd have been pointing out for years, growth in demand for oil is exceeding that of new supply.

The end result has been a rise in the equilibrium price of oil. OPEC countries appear to be reinforcing this, with falls in the oil price below $US100 a barrel being met with supply cutbacks, as OPEC countries seek to maintain their revenue flow in order to fund stepped-up public spending.

Secondly, oil prices have benefitted from an improvement in the global growth outlook. This has been seen in most growth assets – shares, commodities and the Australian dollar – which have all rebounded over the last few months and oil has been caught up in this. This has been accentuated more recently by a renewed fall in the US dollar, since oil is priced in the currency.

Finally, we have seen a renewed rise in the geopolitical risk premium associated with tension in the Middle East. Iran is at the centre of this, with Western countries moving to impose an embargo on Iranian oil and Iran in turn threatening to close the Strait of Hormuz. At the same time, the civil war in Syria is worsening, bringing with it the risk of Western intervention which in turn runs the risk of further inflaming tensions in the Middle East (Syria is an Iranian ally). Syria is not a big oil exporter, but Iran exports roughly 2.5 million barrels a day – compared to global oil production of 90 million barrels a day – posing a bigger threat than Libya last year, which exported 1.5 million barrels a day. This can be made up for by Saudi Arabia, which has roughly 2 million barrels a day of spare capacity. A bigger problem would arise if Iran did “close” the Strait of Hormuz, as some 16 million barrels (or 18%) of world oil production flows though it each day.

The question then becomes how far Iran is prepared to go before it backs down. Economic pressure on Iran is mounting and the current Iranian regime would probably not like to go the way of Saddam Hussein’s Iraq or Colonel Qaddafi’s Libya. Then again, I am not a Middle East political expert.

Oil prices and the global economy

What happens if the situation regarding Iran continues to escalate? Past oil price surges have clearly played a role in triggering US and global downturns (see the next chart).

It’s not so much the oil price level that counts as its rate of change, as businesses and consumers get used to higher prices over time. Trouble normally ensues if the oil price doubles over 12 months and we are nowhere near that – West Texas Intermediate (which is constrained by a US oil production surge and transport constraints) is up 10% year-on-year, Brent is up 9% and Tapis is up 15%. US household spending on energy as a share of income is not historically high, and the oil price surge has occurred when the labour market is improving. Our view is that the world can probably live with West Texas Intermediate at around $US110 a barrel (or Brent around $US120). The following table estimates the impact on GDP of a $US10 rise in the price of oil for the year ahead (in the second column) and then applies that to the impact of oil at $US120 a barrel and $US150 a barrel.

-Impact on GDP of rising oil prices, % points
Country
Impact of $10 rise in oil price
Impact of oil at $1.20 *
Impact of oil at $1.50 *
US
-0.3
-0.3
-1.2
Europe
-0.5
-0.5
-2
Japan
-0.3
-0.3
-1.2
Asia
-0.8
-0.8
-3.2
World
-0.4
-0.4
-1.6
Australia
-0.25
-0.25
-1

Global growth this year is currently forecast to be around 3%, so if the world oil price (WTI) settles around $US120 a barrel, then global growth would be reduced to around 2.6% – i.e. soft but not disastrous. However, a sustained spike to $US150 a barrel would be much more worrying. Asia is the most vulnerable, reflecting its heavy reliance on imported oil and its more intensive oil use. Australia is less vulnerable as it is a net energy exporter.

The rise in the oil price will also boost inflation, with roughly a $US10 a barrel rise adding 0.5% to inflation in the US and Australia and 0.7% to inflation in Asia. Given the negative growth impact though, it’s hard to see central banks reacting.

The bottom line is that current oil price levels are probably not enough to derail the global recovery. However, if oil prices rise to $US150 a barrel the threat would be significant.

Impact on Australia

While the strong Australian dollar acts as a buffer, the protection is only partial, as so far this year the Asian Tapis oil price is up 13.8% in US dollars, whereas the Australian dollar is up only 5.8%. Australian petrol prices have already risen to around $1.46 a litre (with a range of around $1.40 to $1.50) and at current oil price levels a further rise in the weekly average petrol price to around $1.53 a litre is likely.

While this will add to headline inflation, the flow on to core inflation is likely to be modest, reflecting constrained corporate pricing power. The more significant impact will be the blow to household spending power implied by higher petrol prices. The rise in petrol prices this year has already pushed the typical Australian family’s weekly petrol bill up to around $51, which is its highest level since July 2008.

Coming at a time of rising prices for necessities such as rent, utilities, health, insurance and education, this will further limit the ability of households to buy discretionary items. Tough times may therefore continue for discretionary retailers for a while yet.

Implications for shares

The surge in oil prices is great for energy shares, but not good for the rest of the market given the impact on profit margins and consumer demand. It has also come at a time when the global economic recovery is fragile. In addition, global shares are a bit vulnerable to a correction after a strong rally – as they were a year ago – and higher oil prices risk being a trigger. Our base case is that the oil price will settle around $US115 for West Texas Intermediate or $US125-130 for Brent and if so, it wouldn’t be a major problem for the global economy and hence sharemarkets. Obviously the risk would rise if the situation regarding Iran escalates – so keep an eye on oil prices.

Dr Shane Oliver is head of investment strategy and chief economist of AMP Capital Investors.

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