Oil prices still on the way up

Oil prices are back as a concern for the global growth and inflation outlook, with prices surging to near $US88 a barrel in the past few days on worries that Turkey might attack Kurdish separatists in northern Iraq. This is now well above last year’s record high of $US78 a barrel. However, the latest surge just looks like a continuation of the three-steps-forward, one-step-back pattern of oil prices over the past few years.

The broad trend is up on rising demand and tight supply. But every so often prices surge as supply worries take hold only to fall back into year end ahead of a new surge the next year. As was the case following the post Hurricane Katrina surge in oil prices in 2005 and last year’s surge in July after Israel invaded Lebanon, the latest rise in the oil price has the potential to create short term jitters about the economic impact and push sharemarkets down. However, the impact is unlikely to be lasting.

Global demand for oil is expected to rise at about 1.5% to 2% annually over the next few decades (even allowing for alternatives and energy efficiencies). If per capita oil consumption in China and India were to rise to just half of Australian and Japanese levels, it would imply an extra 39 million barrels a day in global oil demand (which is currently 85.9 million barrels a day).

Global oil production is still rising, belying the alarmist “peak oil” predictions of an imminent peak, but supply is constrained by years of low exploration, diminishing returns and the rising cost of extracting new oil.

Strong long-term growth in demand but constrained supply implies the long-term trend in the oil price will remain up. In this environment anything that may threaten the supply of oil will have a disproportionate positive impact on the oil price, as we have seen in the past few days. Our assessment remains that an oil price above $US100 a barrel is likely some time in the next few years.

The short-term outlook
While the oil price may head even higher in the weeks ahead, particularly if Turkey does go into northern Iraq, oil prices are likely to fall into year end.

The normal seasonal pattern is for oil prices to fall though the December quarter after the northern hemisphere “summer driving” season winds down.

More fundamentally, growth in global oil demand has slowed down to less than 1% a year, led by the US where its economic slowdown has seen oil demand stall. With global growth set to moderate a touch over the next year, this will keep short-term oil demand subdued.

While the market is currently fretting about the impact of Turkey disrupting the flow of oil through Northern Iraq, only a small amount of oil passes through there so the impact is likely to be very small. In any case, OPEC spare capacity is now around 3.5 million barrels a day with Saudi Arabia (which is producing about 8.7 million barrels a day, with spare capacity of 2.6 million barrels per day [mbd]) easily able to make up any new short fall in Iraq’s current meagre production (running at 2 mbd).


First, Australian petrol prices are likely to push higher in the weeks ahead. There is a close relationship between world oil prices in Australian dollars and Australian petrol prices. Australian retail petrol prices surged earlier this year relative to what was implied by global oil prices and the $A, but since June they have been surprisingly low as discounting picked up helped by the Treasurer’s announcement of another petrol price inquiry. However, if the world oil price stays around current levels then at least a 10¢-a-litre rise in the average weekly petrol price is likely over the next few weeks.

Second, the latest spike in oil prices is likely to add to worries about global and local economic growth. But, just as we have seen over the past few years, the impact is likely to be mild. The rise in oil prices still largely represents an ongoing demand shock, not a 1970s style reduction in oil supply and the rise in oil prices remains orderly compared to the 1970s surges.

Australian consumers seem to be shrugging off the petrol price shock. This is evident in the fact that consumer confidence in Australia is still around where it was when the petrol price was below $1 a litre. The pain threshold for petrol prices has been steadily rising and this is also the case globally.

The inflationary effect of higher petrol prices is likely to remain pretty non-existent, thanks to global competition.

Third, the continuing rising trend in oil prices remains good news for energy shares. A higher oil price usually results in the outperformance of Australian energy shares relative to the broader sharemarket. A $US10 rise in the oil price should see energy shares outperform the broader market by 15%. Right now energy share prices have a bit of catching up to do, running well below the trend.

Finally, while higher oil prices are good news for energy shares, the latest spike has the potential to cause a further short-term correction in sharemarkets as investors fret about the broader economic impact. Shares are vulnerable to a correction after rising sharply since mid-August. However, while shares may experience a short-term correction, we remain of the view that they will be higher into year end helped by further US interest rate cuts and still reasonable valuations.

The trend in oil prices is likely to remain up, but barring a major supply shock such as a war in the Middle East the process is likely to remain orderly. Although the latest spike has the potential to create short-term jitters among investors, it is unlikely to be lasting.

A longer version of this story first appeared in the Eureka Report.



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