Key points

• Global oil prices remain under upward pressure from turmoil in the Middle East and North Africa. This will dampen global growth and add to the financial pressure on Australian households.
• The global and Australian economies and share markets can probably live with current oil price levels. However, a sustained sharp rise in the oil price to $US140 would make life a lot more difficult.

Oil prices are surging again

After a dip last week on the back of the tragedy in Japan the US West Texas Intermediate oil price is back above $US105 a barrel and Asian Tapis oil prices are around $US120 a barrel.

Source: Thomson Financial, AMP Capital Investors

Increasing tensions in the Middle East and North Africa (MENA) have been the primary driver, with the US and various European countries now intervening militarily in Libya to enforce a no fly zone, along with escalating tensions in Bahrain, Yemen and Saudi Arabia. The tensions between Sunni rulers and Shiites in Bahrain risk a further escalation, possibly drawing in Shiite dominated areas in Saudi Arabia and Shiite dominated Iran.

In addition, the lessening of the risk of a full blown nuclear meltdown in Japan has shifted the focus back to increased oil demand from Japan in order to make up for reduced nuclear power production and as part of rebuilding demand following the earthquake. This is all occurring at a time when global demand for oil is rising on the back of the global economic recovery and a long term deterioration in the pace of new oil discoveries.

The rise in the oil prices is pushing up energy costs world wide. Australia is no exception, and the rise to date has pushed up local petrol prices to an average of around $1.45 a litre. As can be seen in the next chart there is a pretty close relationship between the local petrol price and the world oil price in Australian dollars. Roughly each $US10 a barrel rise in the world oil price translates to around an 8 cents a litre increase in Australian petrol prices. If world oil prices stay at current levels expect petrol prices to rise another 3 to 5 cents over the next few weeks.

Source: Thomson Financial, AMP Capital Investors

The war in Libya has affected most of its normal 1.8 million barrels per day of oil production. Prior to the unrest in the Middle East, OPEC had 5 million barrels a day of spare oil capacity and so Saudi Arabia and other gulf states have been able to make up for lost Libyan production.

Source: Bloomberg, AMP Capital Investors

However, Libyan crude oil is light and cheaper to refine compared to the heavy Saudi oil grades, so this has added to the price of light oil grades such as Brent and Tapis. Secondly, while OPEC can make up for lost Libyan production it, would only take a spreading of unrest and production disruptions to say Kuwait, Iran or part of Saudi Arabia to wipe out all of the spare capacity. Finally, some suspect Saudi Arabia may be exaggerating its spare capacity. So it’s little wonder the oil price contains a risk premium, estimated to be around $US10-15 a barrel. If the unrest spreads, a further increase in oil prices is likely.

While not experts on the Middle East, our sense is that, although the turmoil will continue to bubble on for a while, further significant oil supply disruption will be avoided. As such the issue will become background noise for global investment markets. However, as the risks are skewed towards more disruption and higher oil prices its worth considering at what level the surge in the oil price would create a problem for the economic outlook.

At what level will the oil price become a problem?

It’s true that past surges in world oil prices have preceded US recessions and sharp global downturns. See next chart.

Source: Thomson Financial, AMP Capital Investors

However, other factors have also been involved – notably significant monetary tightening, and we are not seeing that now. Much of the rise over the last two years has also been due to stronger demand with supply concerns only adding $US10-15 a barrel this year. It’s also the change in the oil price that matters, not its level, as businesses and consumers gradually get used to higher oil prices. Trouble normally ensues if the oil price doubles over 12 months. We are not quite there yet. Our assessment is that the world can probably live with oil around $US100 a barrel, and we expected it to reach that level this year anyway.

The following table estimates the impact on GDP growth of a $US10 rise in the price of oil for the year ahead in the second column and then applying that to the impact of oil at $US110 a barrel and $US140 a barrel.

Impact on GDP growth of rising oil prices, % points

* Relative to a base case of $US100. Source: IEA, IMF, OECD, AMP Capital Investors

Global growth this year is currently forecast to be around 4.3% by the IMF so if the world oil price settles around $US110 a barrel then global growth would be reduced by around 0.4% but would still be solid at around 3.9%.

However, a sustained spike to $US140 a barrel would be much more worrying as it would slice around 1.6% off world growth, 1.2% off US growth and 1% off Australian growth. 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.

What would central banks focus on – inflation or growth? The European Central Bank is more likely to focus on headline inflation and so raise interest rates as it is threatening to do. However, the US Federal Reserve is likely to see a fuel inspired boost to inflation as temporary and would probably give more weight to weaker growth.

At this stage it’s too early to get overly worried given that it’s quite possible that significant tensions in the Middle East and North Africa will be confined to current countries. Just as the much feared nuclear meltdown didn’t happen a week ago, a worst case oil price surge may be avoided. The bottom line is that current oil price levels are probably not enough to derail the global recovery. However, if oil prices rise to $US140 a barrel the threat would be significant – both via the direct hit to growth and the indirect hit if central banks in some countries respond to higher inflation via interest rate hikes.

What about Australia?

For Australia, the strong Australian dollar is acting as a buffer against the rising oil price. Australia is also a net energy exporter and so the rise in the oil price is providing a boost to national income via higher gas and steaming coal prices. We also see the RBA giving more weight to the growth reducing impact of higher oil prices rather than the boost to headline inflation and so don’t see it responding with a rate hike, providing underlying inflation stays benign.

The real problem for Australia is that the rise in oil and petrol prices will add to consumer caution. While higher energy prices boost national income, and hence resource sector investment, the rise in petrol prices over the last month has already added another $5 a week to the weekly petrol bill for a typical Australian family. It is now just $10 a week below the 2008 high.  Coming on the back of solid increases in costs for electricity, insurance, fresh food and education this will only cut further into consumer discretionary spending power. More bad news for retailers.

Source: AMP Capital Investors

Implications for shares

The surge in oil prices is great news for energy shares, but not so good for the rest of the share market. However, shares can probably still perform well with current oil price levels, helped by the improvement in valuations after the recent correction. However, a sustained sharp rise in the oil price to around $US140 would make life a lot more difficult.

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International equity fund manager, Insync Funds Management, considers the key global investor themes of 2011-2012:

• China – we believe inflation in China will emerge as a much bigger theme than the markets are anticipating in the coming months

After the GFC China really opened the floodgates of monetary and fiscal policy, money supply has increased over 50% in the last two years and the Government has embarked on a public works program that is the biggest since WW2 – to put this into context there are currently 7000 skyscrapers under construction in China compared to only three in the US!

Fixed investment is running at over 50% of GDP and this is clearly unsustainable. (the US peaked at 18% in their recent construction boom). Our sources tell us that inflation could be double the reported figure of 5% and this will require China to slow growth dramatically to bring this under control.  This will have an obvious impact on the Australian economy and we expect the Australian currency to weaken over time.

• Higher inflation is not only limited to China; much of the emerging world has inflation rates that are higher than the authorities would like

In fact, this is one of the primary causes of the unrest that is sweeping the Middle East. This will require a tightening of policy in those countries as well as slower growth.

• In Europe we do not believe the peripheral debt issues have been resolved but have only been deferred

This is confirmed by the credit markets where spreads are still at very high levels. At some point Governments will have to face reality and look at some form of restructuring – which will most likely involve some pain to bondholders.

• Finally, we believe the US economy may surprise to the upside this year

Corporations (especially large multinationals) are sitting on record levels of cash and this combined with accelerated depreciation in the US will lead to a decent recovery in corporate investment. In addition, the US is still home to the best companies in the world, many of which have large global operations (50% of the S&P earnings are ex US).

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Russell Investments is expecting a slow motion market recovery, according to its March 2011 market commentary. Andrew Pease, chief investment strategist, tells investors to be optimistic but not too optimistic:

• Russell is moderately bullish on global equities, expecting returns to be in the high single to low double digit range. This is below some analyst predictions of 20%, but Pease urges investors to learn lessons from the past. “Only last August everyone was concerned about a potential double dip, but they’ve been quick to upgrade their forecasts for share market returns. Just as they were too pessimistic then, investors should be optimistic but not too optimistic now,” he said.
• The motto for Australian equities in 2010 was “less pain means less gain” and this proved true with the ASX 200 eking out a 2% return compared to 13% for the MSCI world index. Russell is slightly less cautious this year, pointing out it would be difficult to argue for a second year of underperformance compared to the rest of the world. But Australian equities will still face headwinds of the high Australian dollar, sluggish economy outside of mining and the potential for more RBA tightening.
• There is going to be continuing market volatility particularly with geopolitical tensions in the Middle East and North Africa. Pease reminds investors Europe could still be in for some flare-ups due to many European policy makers having a reactive rather than proactive policy.
• Rising oil prices could cap Russell’s forecast at the lower end of the range, but Pease says oil would have to sit over $130 per barrel for a sustained period before he revised his forecast.

Click here to download this document (pdf)

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• According to the Australian Institute of Petroleum, the national average Australian price of unleaded petrol rose by 2.9 cents per litre to 139.2 cents a litre in the week to March 6 – a near 29 month high. Over the past three weeks the national average price has lifted by 4.4 cents per litre.
• Motorists are likely to see a further increase in petrol prices over the coming weeks. While the Singapore unleaded price has lifted by more than US$15 a barrel in the past three weeks, it has only partially filtered through to the terminal gate (wholesale) price – which gained 6 cents a litre in the last three weeks. CommSec expects pump prices to rise by a further 4 cents a litre in the next fortnight.
• Job market looks set to tighten further. The Advantage internet job index rose by 6.1 per cent in February. The ANZ job ads index rose by a 1.2 per cent in February after an upwardly revised 3.0 per cent rise in the prior month.
• The construction sector is still contracting despite a modest improvement. The Performance of Construction index rose by 4.4 points to 44.6 in February.

What does it all mean?

• At present petrol prices are going only one way – up. Petrol prices have surged by almost 3 cents a litre in the past week and are holding near 29-month highs and unfortunately for motorists it is unlikely to get any better over the next couple of weeks.
• The political instability in the Middle East and North Africa is the key driver of near term prices. And given the current tensions in the Middle East, the Singapore unleaded price has surged by over US$15 a barrel in the past three weeks and is holding at 30-month highs. Unfortunately for motorists the Australian dollar can only do so much, and as such most of the increase in the global oil price will need to filter through to domestic pump prices.
• The terminal gate price (wholesale) is certainly responding, lifting a sizeable six cents a litre since bottoming out three weeks ago. CommSec expects prices to increase by 4 cents a litre in the next fortnight, taking the national average price to around $1.44 a litre. At the high point of the discounting cycle petrol will be trading well above $1.50 a litre.
• The labour market has been the shining indicator over the past year and the latest job ads data suggests that employment growth is likely to be healthy in coming months. The Advantage job index has once again tracked higher after a bout of recent weakness, while the ANZ job ads series has once again shown moderate growth. Importantly while the labour market is likely to strengthen in coming months it is unlikely to see robust growth akin to 2010 – especially given that the domestic economy has lost momentum in recent months.
• The labour market will be one of the key hot issues that the Reserve Bank will be focusing on in coming months. As long as the supply of labour remains adequate, the Reserve Bank can remain on the interest rate sidelines.

What do the figures show?

Petrol prices:

• According to the Australian Institute of Petroleum, the national average Australian price of unleaded petrol rose by 2.9 cents a litre to 139.2 cents a litre in the week to March 6. The metropolitan price rose by 3.0 c/l to 139.1 c/l, while the regional average price rose by 2.7 c/l to 139.3 c/l.
• Average petrol prices across states over the past week were: Sydney (up 2.1 cents to 138.7 c/l), Melbourne (up 3.5 cents to 138.7 c/l), Brisbane (up 3.0 cents to 140.7 c/l), Adelaide (up 4.8 cents to 139.5 c/l), Perth (up 3.2 cents to 138.8 c/l), Darwin (up 4.1 cents to 143.1 c/l), Canberra (up 0.3 cents to 134.0 c/l) and Hobart (up 3.1 cents to 144.1 c/l).
• Today, the national average wholesale (terminal gate) stands at a near 29-month high of 133.7 cents a litre, up 3.7 cents a litre over the past week.
• Last week, the key Singapore unleaded petrol price rose by US$4.83 (4.1 per cent) to US$123.60 a barrel – a 30 month high. And in Australian dollar terms the Singapore gasoline price rose by $4.68 (4.0 per cent) over the week to $121.88 a barrel.

Performance of Construction:

• The Performance of Construction index rose by 4.4 points to 44.6 in February. Any reading below 50.0 indicates the sector is contracting. Houses, apartments, and commercial construction were all below 50, while the engineering sector expanded after contracting in the prior month.

Job advertisements:

• The Advantage internet job index rose by 6.1 per cent in February. Job ads were strongest in the ACT (up 15.3 per cent) followed by Queensland (up 8.3 per cent), NSW (up 6.4 per cent), Western Australia (up 6.1 per cent), Victoria (up 4.9 per cent), South Australia (up 4.4 per cent), and Tasmania (up 1.5 per cent). Across sectors, gains were recorded for Transport (12.8 per cent), Administration, clerical and office support (11.4per cent) and trade services (10.3 per cent). Declines were recorded only in education (-0.8 per cent).
• Similarly the combined number of internet and newspaper job advertisements, as tracked by ANZ, rose by 1.2 per cent in February after a upwardly revised 3.0 per cent increase in January. Internet job ads rose by 1.0 per cent in the month, while newspaper job ads rose by 4.4 per cent. In annual terms job ads are up 19.3 per cent.

What is the importance of the economic data?

• Weekly figures on petrol prices are compiled by ORIMA Research on behalf of the Australian Institute of Petroleum. National average retail prices are calculated as the weighted average of each State/Territory’s metropolitan and non-metropolitan retail petrol prices, with the weights based on the number of registered petrol vehicles in each of these regions.
• The monthly Job Advertisements release is a leading employment indicator. Employers only seek additional staff if business activity is strong, and more importantly, if they expect that conditions will remain favourable in coming months. It takes around 5-6 months for the new staff to be added to the payrolls. But a fall in job advertisements would have a more immediate impact on monthly employment estimates.
• The monthly Performance of Construction Index is a gauge of operation conditions across residential, commercial and engineering construction. The PCI is useful not just in showing how the construction sector is performing but in providing some sense about where it is heading. The key ‘forward looking’ components are orders and employment..

What are the implications for interest rates and investors?

• The lift in the price of petrol is further bad news for motorists, taking precious spending dollars out of consumer pockets. Retailers already have to contend with the effects of the weather on seasonal spending, consumer conservatism and higher utility prices.
• Filling up the car with petrol is the single biggest outlay that Aussie households make each week so changes in petrol prices have a big impact on the budget and spending patterns. The average household is paying almost an additional $30 a month more on petrol compared with just over six months ago.

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The recent geo-political tension in the Middle East and Northern Africa has again highlighted the sensitivity of crude oil prices to supply threats, with WTI crude oil climbing close to $100 per barrel recently.

There is speculation as to how high it can go and so far analysts have capped the price rise to a maximum of $140-$150 a barrel. However Ben Le Brun, market analyst at CMC Markets, says it could react more aggressively if there is an actual supply disruption as opposed to a threatened disruption. At this stage OPEC has kept the world well supplied and does have the ability to pick up any slack but things could soon change as the region is responsible for supplying 36 percent of the world’s oil, Mr Le Brun says. He has conducted a 20 year analysis which shows it is not usual for oil prices to double during times of crisis: But traders should use caution if trying to profit as the price can swing about wildly and unpredictably in times of crisis.

• During the Yom Kippur War the price of crude oil went from $3.00 per barrel in 1972 to $12.00 by the end of 1974. The Yom Kippur War sparked an oil export embargo by several countries and resulted in a loss of 7 percent of the free world oil production. This oil embargo made prices extremely sensitive, increasing 400 percent in six months. In today’s terms that would be equivalent to the WTI oil price hitting $360 a barrel
• The Iranian revolution and the Iraq-Iran War again highlighted the rise in price caused by actual as opposed to threatened supply disruptions. Crude oil prices more than doubled, increasing from $14 in 1978 to $35 per barrel in 1981.
• The price of oil again spiked in 1990 when the onset of the Gulf War and its proximity to the world’s largest producer, Saudi Arabia, put oil production in jeopardy. The price went from $21 in July 1990 to $46 by mid October. This spike was much less than some had anticipated but the price did double with fears.
• After September 11 2001 and the outbreak of the Afghanistan war the price of oil was initially sold off. It was not until the start of the Iraq War II in 2003 that OPEC had to ramp up production of oil to keep the supply chain going. Prices actually went down at the outset of the Iraq war with most traders predicting a swift end to the conflict but by late 2003 the oil price began to rise as insurgent activity began to affect the oil supply. Prices hovered around $30 when OPEC cut production and in 2004 hit $40 a barrel. OPEC subsequently raised production but terrorists targeted oil supply and later in the year oil touched $50.

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