Oil’s double hit on Australia

Summary: The rising oil price is hurting consumers, but boosting the share prices of producers.

Key take-out: Our economy will take a big hit if oil keeps rising and the dollar falls further.

Oil prices have eased slightly this week, but so has the Australian dollar. That combination means Australian business and households are paying the highest local prices in a decade for petroleum and other oil-based products.

The impact of the local oil price rising by 53 per cent since the start of the year can be seen in a negative and positive light. Share prices of heavy oil users are down, while oil and gas producers are up, and rising.

At its simplest, the situation forms a neat oil-focussed investment strategy of buying producers and selling consumers, though it is never that easy in playing a commodity well-known for its sharp movements up, and down.

Despite the complexity of the oil market, what’s happening today is starting to have a measurable effect on the broader Australian economy, which is more dependent on road and air transport than most countries.

A look at the commodity-plus-currency combination starts in the international oil market where trades are invariably booked in US dollars. The price of Brent-quality crude (the European standard) has been rising since the start of the year by 38.5 per cent from $US60.46 a barrel to the latest price of $US83.75/bbl. It has been driven by demand, limited production growth and concern about US sanctions inhibiting supply from major oil exporter Iran.

But in Australia, that 38.5 per cent rise in the international oil price has been boosted by a 10 per cent decline in the value of the Australian dollar since the start of the year from around US78 cents to $US70.5c. This has lifted the local oil price by the 53 per cent mentioned earlier, from $77/bbl to $118/bbl.

Earlier this week we flagged the higher investment returns that have been enjoyed by many Australian investors exposed to the US stock market, largely thanks to our falling dollar. But Australians are on the receiving end of that exchange rate, especially at the petrol bowser but also in terms of any purchases that involve transportation.

The last big oil shock

The oil price in Australian dollars has been higher in the past, though not by much, and you have to go back to 2008 to find a more damaging combination of commodity and currency.

It was in July 2008 that the worst effect of an oil price boom and an Australian dollar slide was being felt, with the international oil price at $US142/bbl and the Australian dollar at US97c, leading to a local oil price of $146/bbl.

But after the 2008 boom came the global financial crisis, which saw the oil price dive before recovering for several years of trading in a range of $US90/bbl to $US120/bbl. It eventually crashed in mid-2014 under the weight of an oil glut.

At the depths of the crash, in early 2016, the price touched a bottom at $US35/bbl, a time when the Australian dollar was at US70c, which translated into a local oil price of $50/bbl.

The reason this look back in time is important is because it puts the price moves over the past 30-months into perspective. A rise from $50/bbl to the current $118/bbl represents a punishing 136 per cent increase in the Australian oil price, a cost increase which flows right through the community.

It’s that more than doubling of the local oil price which explains why businesses and households are hurting and why the economy could take a hit equivalent to an interest rate increase.

Oil price turbulence

The easiest way to measure the impact on business is through the share price of Qantas, one of Australia’s biggest oil users. Even though it buys its aviation fuel in US dollars, and hedges most of its purchases to smooth price moves, it is not possible over time to totally dodge a rising oil price.

Since the middle of the year, as oil started its latest upward move and the decline of the Australian dollar accelerated, the Qantas share price has fallen by $1.33, or 19.5 per cent, to $5.48.

On the other side of the oil equation, oil-producer share prices have been marching higher. Woodside, Oil Search and Beach are all up by around 7 per cent.

What happens next is keeping investors and oil consumers on their toes because of the potential for the oil price to continue rising as geopolitical tensions shake the Middle East, the world’s major oil-producing region, and the US maintains sanctions pressure on Iran.

Talk of oil returning to $US100/bbl is widespread, and while it appears to be readily available, big bets are being placed in the futures market that trouble in Iran could see an oil shortage develop.

According to a Reuters report, open positions in futures trading on oil at $US100/bbl in December next year have risen by 30 per cent in the past week to a record 31,000 lots.

John Saucer, vice-president of research and analysis at Mobius Risk Group, said the US sanctions pointed to big oil importers such as India and China not buying Iranian crude after November.

“The sanctions are likely to be a lot more effective than most people thought,” he said.

UBS analyst, Giovanni Staunovo, said his firm continued to see price risks tilted to the upside and “we do not rule out a spike in oil prices to $US100/bbl”.

Currency drop a risk

For Australia the outlook is further clouded by currency moves, because if oil does hit $US100/bbl and the Australian dollar stays at US70c, the local oil price will rise to $143/bbl, close to its 2008 high of $146/bbl.

The downside for the economy could be worse if the Australian dollar slips further, a possibility if the Reserve Bank trims interest rates in the face of a global slowdown.

Some currency analysts are already forecasting an exchange rate as low as US65c, a downward move which would reflect the continuing strength of the US dollar which has boomed on a combination of strong economic growth and tax cuts.

“Fiscal stimulus on top of a growing economy is forcing the Federal Reserve (bank) to hike interest rates,” Vimal Gor, head of fixed interest at Pendal Group told the Australian Financial Review newspaper.

“We think this is a perfect storm for the US dollar,” he said.

In contrast, the Australian dollar is being traded as a proxy for the economic slowdown in China, making a US65c exchange rate a possibility. While that might help exporters, it will deliver a further damaging increase in the oil price.

At US65c and at an oil price of $US100/bbl, the Australian price would soar to around $153/bbl. Such a price would have a significant impact on every business and household, with a rippling effect on consumer spending and investment.