The latest rise in oil/petrol prices is likely to constrain retail sales and will be a constraint on interest rates.
Strong demand and constrained supply
From an average of $US30/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/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/day), problems in Nigeria and US refinery issues.
Where to for the oil price – long term trend is up
Our assessment remains that the longer term pressure on oil prices remains upwards:
On the demand side, as both China and India and other emerging countries industrialise it is resulting in massive demand for things like cars, TV’s and mobile phones, which is resulting in a corresponding increase in demand for commodities like oil. Chinese per capita oil consumption is just 2 barrels a year. If this were to catch up to Australian or Japanese consumption levels (15 barrels per person a year), because of China’s 1.3 billion population it will 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.
Source: Thomson Financial, IMF, AMP Capital Investors
Oil supply is likely to be constrained. While we are not as bearish as the “Peak Oil” advocates who claim that global oil production is close to peaking[1], oil production is unlikely to be able to rise in line with demand. OPEC’s spare capacity is low (running at around 2 million barrels a day compared to around 6 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 & 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 around 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. Since 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 is quite likely over the next few years, but hopefully 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 around $US80/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 quickly go away and if anything may worsen;
- While US crude oil stockpiles are running above normal levels, OECD stock piles are around average levels.
Furthermore, gasoline inventories are now being rundown 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 around September and then fall back; there is no reason to expect anything different this time around. In this context it wouldn’t be surprising to see the oil price head up to around $US80/barrel by around September before slipping back a notch. In other words just a continuation of the two steps forward, one step back pattern for the oil price as seen over the last few years.
$US80/barrel would translate to around $A1.40/litre or thereabouts 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/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 steadily rising from an average $US30/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 five fold 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:
Source: Thomson Financial, AMP Capital Investors
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, whereas today it takes up 6.3%.
Oil prices compared to other prices
Jan 1980 | Now | % chg | |
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 | $0.525 | $1.95 | +271 |
Holden Commodore | $7,903 | $32,990 | +317 |
Average weekly wage | $223.6 | $1026.0 | +359 |
Avg Austhouse 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 around last September/October after oil prices first spiked to $US70/barrel, but they have since recovered as consumers became used to higher petrol prices. It is likely that the current surge in oil prices will result in slower retail sales through May until consumers get used to the new higher level for 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 the $US100/barrel level 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/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 last 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 & heavy industrials as their costs rise.
More broadly, the latest spike in the oil price occurring at the same time as the back up in global bond yields risks a broader correction in share markets 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 hike.
By Dr Shane Oliver, chief economist and head of investment strategy at AMP Capital Investors.*
[1] 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.
