Oliver's Insights: Oil Prices

KEY POINTS:

• Strong demand and ongoing supply concerns have sent oil prices back above $US70 a barrel.
• The longer-term trend in the oil price is likely to remain upwards, but providing it remains a steady rise the economic fallout should remain minimal.
• The latest rise in oil/petrol prices is likely to act as a constraint on retail sales and on interest rates.

FROM AN AVERAGE of $US30 a barrel in 2003, world oil prices have been trending ever higher. This is despite the occasional setback sparked in part by concerns that high oil prices will lead to slower economic growth and hence crimp oil demand. The key driver behind the rising trend in oil prices has been strong demand for oil, reflecting in large part the industrialisation of China and India at a time when global oil production is constrained.

The tight supply/demand balance has left the oil market vulnerable to anything that may disrupt supply, including terrorist attacks, political developments in supplier nations, and hurricanes. The current spike in the oil price back above $US70 a barrel reflects a combination of factors including concerns that the standoff over Iran’s nuclear ambitions will lead to a disruption in the supply of Iranian oil (about 3.9 million barrels a day), problems in Nigeria and US refinery issues.

Our assessment remains that the longer-term pressure on oil prices remains upwards:

• On the demand side, the industrialisation of China, India and other emerging countries is producing massive demand for such things as cars, televisions and mobile phones '” and a corresponding thirst for oil. China’s per capita oil consumption is just two barrels a year. If this were to catch up to Australian or Japanese consumption levels, of 15 barrels, its population of 1.3 billion would add about 17 billion barrels to annual global oil consumption needs compared to current production of 30 billion barrels. If the same were to happen in India (where per capita oil consumption is 0.8 barrels a year) world oil production would need to rise by another 14 billion barrels a year. This will occur over time but the point is that long-term oil demand growth will be strong, as illustrated in the IMF projections in the next chart.

• Oil supply is likely to be constrained. Although we are not as bearish as the “Peak Oil” advocates who claim that global oil production is close to peaking, oil production is unlikely to be able to rise in line with demand. (Peak Oil claims have numerous flaws. They ignore the role of Middle East politics and low real oil prices until recently in driving the “low” discoveries of recent years, oil field discoveries have been higher than Peak Oil protagonists have allowed for, the timing of the “peak” has been pushed out and they ignore the role of new technology.)

OPEC’s spare capacity is low (running at about two million barrels a day compared to about six million barrels a day four years ago); growth in Russian oil production is constrained by poor infrastructure; existing oil fields are experiencing diminishing returns; the cost of extracting new oil is rising; and there has been a lack of exploration after years of low real oil prices and political constraints in the Middle East. The discovery of new oil reserves is currently running about 10 billion barrels per annum compared to 40–50 billion in the late 1950s/early 1960s.

The combination of strong growth in demand but with constrained supply implies upward pressure on oil prices over the longer term. Because the price will have to balance supply and demand it will have to be high enough to encourage a combination of more oil efficiencies, the use of alternative energy sources and new exploration to increase oil production. Our assessment remains that an oil price above $US100 a barrel is quite likely over the next few years, but it is to be hoped it won’t get there in a straight line. In the short term, a combination of factors suggest that the oil price will probably go higher, possibly to about $US80 a barrel by August/September:

• We are approaching the northern hemisphere driving season and the hurricane season in the Gulf of Mexico.

• Tensions regarding Iran and disruptions in Nigeria are unlikely to go away quickly. If anything, they may worsen.

• While US crude oil stockpiles are running above normal levels, OECD stockpiles are about average levels. Further, gasoline inventories are now being run down, in part reflecting a switch over to tougher fuel standards in the US.

The normal seasonal pattern is for the oil price to move upwards until about September and then fall back; there is no reason to expect anything different this time around. In this context, it would not be surprising to see the oil price head up to about $US80 a barrel by about September before slipping back a notch. In other words, a continuation of the two steps forward, one step back pattern we have seen in oil over the past few years. Oil at $US80 a barrel would translate to about $1.40a litre at the pump for Australian motorists.

ECONOMIC IMPLICATIONS '” LITTLE IMPACT SO FAR

High oil prices are negative for economic growth because they add to production costs, are a tax on consumers and reduce confidence. Past relationships suggest that each $US10 a barrel rise in oil prices will knock 0.5% from world growth, 0.3% from Australian growth and add 0.5% or so to inflation within a year. However, the oil price has been rising steadily from an average $US30 a barrel in 2003 and there has been little economic impact so far. Global and Australian growth remains robust and inflation remains benign.

There are several reasons why the impact has been so muted this time around: the size of the price rise shock is far less than in the 1970s '” oil prices rose fivefold in 1973; it reflects a demand shock rather than a 1970s-style supply shock; the usage of oil per unit of GDP in developed countries has halved compared to 1970s levels; surging Chinese exports are helping suppress inflation; and the real price of oil is still well below previous peaks. The next chart shows that in today’s dollars oil prices are still below their peak 1980 levels:

The rise in oil prices since 1980 is still quite mild compared to the rise in prices for a whole range of other goods, wages, houses and shares. Back in 1980, putting 50 litres of petrol into a car would have taken up 7.4% of average weekly wages in Australia; today it takes up 6.3%.

HOW OIL PRICES COMPARE
	January 1980	Now	Change %
World oil price, $US/barrel	$US40	$US70	75
World oil price, $A/barrel	$36	$95	164
Litre of petrol	$0.33	$1.29	291
CPI	45.7	150.6	230
Litre of milk	$0.53	$1.95	271
Holden Commodore	$7,903	$32,990	317
Average weekly wage	$223.60	$1,026.00	359
Avg Aust house prices	$48,259	$402,181	700
All Ords share index	586	5200	787
Source: Thomson Financial, AMP Capital Investors

Additionally, the impact on Australia is likely to remain less negative compared to other countries because it is being accompanied by strong energy prices generally and Australia is a net energy exporter.

This is not to say the rise in oil prices is of no economic consequence. Periodic spikes in the oil price are clearly having a negative impact on consumer spending. Retail sales slumped in September/October last year after oil prices first spiked to $US70 a barrel, but have recovered as consumers became used to higher petrol prices. It is likely the current surge in oil prices will result in slower retail sales through May until consumers get used to the new prices.

Our assessment is that the impact of higher oil prices on global and Australian economic growth and inflation will remain muted for the same reasons that it has been so far. As such, we don’t see slower economic growth threatening our assessment that the oil price will trend higher taking it above $US100 a barrel over the next few years. This was the level oil prices reached in today’s dollars in the early 1980s, after which energy efficiencies and alternatives were adopted.

The economic impact will also depend on how quickly the oil price rises. If $US100 a barrel is reached steadily over several years in response to global demand, consumers and businesses would have time to adjust. This is essentially the experience of the past few years. However, if it occurred over a few months, say, due to sanctions on Iran, it could cause a global recession.

IMPLICATIONS FOR INVESTORS

The favourable long term backdrop for oil and other energy prices suggests cyclical set backs are likely to be mild and should be used as a buying opportunity for energy-related investments. On the flip side, rising oil prices are negative for transport shares and heavy industrials as their costs rise.

More broadly, the latest spike in the oil price occurring at the same time as the backup in global bond yields risks a broader correction in sharemarkets as investors fret about the economic fallout, as occurred around April and October last year. However, providing the economic impact remains muted (as we expect to be the case) then the impact on share markets will be mild and temporary.

To the extent that the rise in oil prices is likely to remain a tax on consumer spending rather than a threat to inflation, it is likely to constrain interest rates. As such, the latest oil price rise provides another reason why the Reserve Bank is unlikely to rush into a May interest rate increase.