Oil on slippery slope
Economists like to talk of a Factor X, a wildcard that creates an unexpected positive or negative shock for financial markets each year. In 2008 it has been more like triple X – the US credit crunch fallout, the oil price, and whether China’s growth will continue.
As Alpha has noted in previous reports, more skeletons in the US credit-crunch closet are likely and the reverberations are yet to be felt fully in Australia. The shock provisioning by the National Australia Bank in July highlights how severe the damage can be.
If truth be known, nobody can predict how bad the US financial crisis will be – that is what makes it such a high-risk event.
BUT AS WE SHOW IN OUR QUARTERLY ALPHA MANAGER REPORT, FEARS OF A SYSTEMIC FAILURE IN THE US ECONOMY ARE NAIVE AND MISPLACED. THERE IS NO QUESTION THAT THE US ECONOMY WILL RECOVER, THE ONLY ISSUE IS HOW LONG THIS WILL TAKE TO PLAY OUT.
But at least Alpha can take a view on the other two wildcards, oil and China. Conditions for both are improving, which augurs well for a modest recovery in global stock markets later this year, and acceleration in 2009/10.
Take oil, for example. After the price rocketed from US$100 to US$150 a barrel in less than six months, some commentators were calling for US$200 a barrel in quick time. The long-term chart below of oil prices (in US dollars) shows the staggering price rise.
The fear is a bubble in the oil price will lead to a severe bout of stagflation: falling growth and rising inflation. Higher oil prices act like a huge tax on economies by lifting the price of transportation and so many other input costs.
Thankfully, oil prices corrected by more than US$20 a barrel in July, prompting some commentators to suggest oil’s bull run was finally ending.
Alpha’s view? We see oil prices retreating to around US$100 a barrel by December and believe the price could remain near those levels for some time. Longer term, oil prices are likely to rise as demand for oil continues to outstrip global supply.
Three factors responsible for the sharp rise in oil prices should unwind in the next six months.
First, speculative activity – thought to be responsible for at least US$20 of the oil price – should ease, amid expectations of falling demand for oil due to high prices.
Second, oil supplies should expand due to more production in the Middle East, especially from Iraq and OPEC countries growing their production capacity this year.
Third, the falling US dollar – thought have added about US$30 to the oil price - might finally strengthen due to rising expectations the US Federal Reserve will lift US interest rates later this year. A higher US dollar should take the edge off commodity speculators.
But ultimately what drives the price of oil, or any commodity, is fundamentals. The huge spike in the oil price is encouraging consumers to use less oil. Demand for energy in the US, which consumes about a quarter of global oil, is down 2% year on year.
US Energy Department data in July showed US crude inventories jumped by 3 million barrels when analysts had expected a decline. US gasoline demand is down 5% year on year. Consumers are responding to high prices by using their cars less.
Of course, a conflict in the Middle East or a strong US hurricane season could see oil prices easily recover their recent losses. But it is likely much of that uncertainty is already built into still stratospheric oil prices.
So expect oil prices to head back towards US$100 a barrel, possibly to the US$90s, late in 2008, in turn reducing pressure on inflation.
Easing inflation will give the Reserve Bank of Australia the room it needs to lower interest rates – possibly the catalyst for the next bull market.
