Rudi On Thursday

This story features ALUMINA LIMITED. For more info SHARE ANALYSIS: AWC

Not one day goes past these days without at least one email entering my inbox with the prediction that oil prices are about to correct from their lofty price levels. Then again, other emails (admittedly less frequent) suggest oil is nowhere near peaking yet.

Yesterday, it was the turn for analysts at Morgan Stanley to suggest that Brent (traditionally at a discount to West Texan Intermediate, the widely used benchmark on the south end of the globe) could well hit US$150 per barrel. Over in London, the team of chartists at Barclays Capital has a similar figure in mind when projecting crude oil futures into the future.

As is always the case at such pivotal points, there is no one general view on what happens next. What I do know, however, is that if oil prices are to remain at current price levels for much longer (or heaven forbid: they do exactly what Morgan Stanley and Barclays Capital think they will do) the world will wake up one morning to the crude realisation that a doubling of the oil price within one year is not good news.

A few signals I picked up this past week already: Credit Suisse and JP Morgan are convinced management at Alumina Ltd ((AWC)) will have to lower market earnings expectations for the company. A key factor in this prediction is: expensive oil (diesel). ANZ economists believe inflation in Australia is about to rise much further than the RBA has feared thus far, and thus further interest rate hikes should be on the horizon. ANZ believes two more hikes of 25 basis points each seems like a feasible scenario. A key factor in this view is: expensive oil.

ABN Amro downgraded its recommendation for food producer Goodman Fielder ((GFF)) on Thursday morning, on lowered earnings expectations for the years ahead. One key factor behind these lowered earnings forecasts is: expensive diesel. ABN Amro analysts are now talking “significantly higher distribution costs”.

This easily explains why market strategists at Deutsche Bank concluded today that the recent rally in global equity markets has been nothing but your typical bear market spike of temporary investor optimism. Says Deutsche: the global financial crisis is far from over, and at some point investors will be drawn to this fact again (always difficult to time these things). In addition, recent strong gains for share markets mean that overall valuations are now less compelling. Most of all, Deutsche notes current earnings expectations foresee quite strong earnings growth for companies in FY09. The strategists’ concern is that this simply means that risks are tilted towards earnings disappointments. Ultimately, says Deutsche, (again: it is very difficult to time these things) a fall in expected earnings will hold the share market back.

Deutsche Bank strategists do not mention expensive oil in their report, focusing on overall declining economic growth instead, but the examples of Alumina Ltd and Goodman Fielder above should leave little doubt that oil at US$130 per barrel is simply a very strong argument in favour of their view.

The implications of expensive oil go much further.

With most industry experts assuming oil would return to sub-US$100 per barrel price levels until recently there is not yet any research available about what the current oil shock will do exactly to the world tomorrow, but instinctively, of course, we all know it cannot be pretty. Since Barclays Capital has been among the most bullish on oil prices, it is probably no coincidence its Emerging Markets specialists this week published a report on what is likely going to happen with the all important Chinese economy.

Take a wild guess.

Barclays believes current market expectations for Chinese GDP growth figures of between 9-10% for this year will prove to be too high. Barclays has penciled in 8.8% itself. This may not seem like a big difference, but look at it from this perspective: Chinese growth in the first quarter was 10.6%, it’ll likely remain high in the current quarter. So what does this mean for the next two quarters?

“Slowdown deepening” reads the title above Barclays’ report. Reading through it one cannot escape how universal the various consequences are of a much higher oil price. In fact, if Barclays would have accidentally replaced “China” with “Australia” in its report, I am sure many would not notice any difference. Consumer budgets are being hit by higher prices for food and petrol (in various forms such as dearer tickets for public transport which is more important in China than in Australia), businesses see their costs rise while demand for their products starts declining, government and central bank are growing worried about taming the inflation ogre (Barclays expects a 50 basis points hike in official interest rates soon), car sales are declining.

There’s one noticeable difference between the economies of China and Australia: the first has just experienced a switch towards the domestic market, while the domestic economy in Australia is poised to underperform in the year ahead. Barclays analysts have already picked up sufficient signals, they report, to believe the Chinese domestic economy is about to lose its eternal miracle tag.

Of course, I hear the market bulls say, we have heard such predictions come and go over the past few years. True. But if ever there was a convincing argument in favour of a noticeable slowdown in China, even more compelling than a US recession, it is expensive oil.

How about expensive oil plus a US recession?

According to the US Department of Energy, the retail price for a gallon of regular gasoline in the US increased by nearly fifteen cents last week to US$3.94 per gallon. So far this year gasoline prices have risen nearly one dollar per gallon.

Ultimately, expensive oil impacts on nearly everything, including its own price and supply and demand dynamics.

So is oil currently digging its own grave, so to speak? The oil sceptics at GaveKal believe the answer is a clear and sound affirmative. GaveKal has gone through some extra efforts lately, publishing reports that seemed to have only one purpose: to make a mockery of all those opinions in the market in favour of oil at US$130-plus per barrel.

Here’s one paragraph that sums it all up nicely: “But surely, you will say, this commodity boom is completely different. Surely it is driven by profound and lasting changes in global supply and demand: China’s insatiable appetite for food and energy, geopolitical conflicts in the Middle east, the peaking of global oil reserves, droughts caused by global warming and so on. All of these fundamental arguments are perfectly valid, but they tell us literally nothing about whether the oil price will soon jump to US$200, stay at US$130 or fall back to US$60 next month.”

And just in case anyone still had any doubts: “the present commodity and oil boom will probably deflate of its own accord since it shows many of the classic symptoms of financial bubbles. This is because the dynamics of today’s commodity markets are not very different from Japan in the 1980s, or technology stocks in the 1990s or, most recently, the housing and mortgage booms.”

Ultimately, warns GaveKal’s oil specialist Ahmad Abdallah, expensively priced oil will simply destruct its own demand. In other words, instead of peak supply maybe the world should start thinking about peak demand. Oil prices rose by a factor of 9 throughout the seventies, which is comparable to current price levels according to GaveKal, but absolute global demand responded by not growing at all for the next ten years. Warns GaveKal: “Demand growth in the OECD is turning increasingly negative, China’s demand growth has halved since 2004 and the figures from other emerging markets are starting to stall.”

In case you are a true believer in the Peak Oil theory, consider that the world still hasn’t genuinely felt the need to become less inefficient in its use of the black liquid. At US$130-plus a barrel, there’s enough pain being inflicted to really start doing something, and fast.

All this is unlikely to happen overnight, right? Well, if today’s email sent out by Nomura to its Asian clients is anything to go by, a sharp correction in the oil price and in share prices of oil companies should become reality sooner rather than later. Nomura advises everyone to get the h*ll out of oil.

Says Nomura: “The movement of a commodity market from backwardation to contango (spot price below futures price) ought to deter and flush out hot money flows, as income from rolling over spot contracts disappears.”

Part of Nomura’s reasoning that a correction is imminent runs through quickly diminishing current account surpluses throughout Asia and other Emerging Market countries (another effect of higher costs of oil) and as such there will be less money flowing into government bonds in G7 countries. This will further push up bond yields and this will act against further significant fund flows out of bonds into commodity markets.

Nomura believes part of the recent oil price spike has been caused by what has become an overcrowded trade; shifting funds from bond and money markets into oil.

“We believe regional upstream oil stocks have become overbought and are at risk of a sharp correction in oil spot prices. Aggressive portfolios should consider shorting oil stocks. We would favour energy infrastructure and nuclear power beneficiaries, since their growth is determined by long-term energy demand from emerging markets, the marginal cost of new supply and substitution. Gold remains a favoured hedge against higher inflation and appears inexpensive versus oil. An upward shift in yield curves ought to be disruptive for all financial assets.”

Ultimately, even shareholders in Woodside Petroleum ((WPL)), Oil Search ((OSH)) and Santos ((OSH)) should be wishing that Nomura’s view is correct, because, as GaveKal puts it, “the higher the price for oil goes, the more radical behaviour change will be and the sooner it will occur. If a high oil price could change behaviour in rich nations in the 1980s, it will surely do the same in poor ones”.

Till next week,

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Greg, Chris, Paula, Sarah, Joyce, Todd, Grahame, George and Pat)

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