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Stronger Oil Increases Risk Of Global Recession

FYI | Jun 12 2008

By Chris Shaw

If US$139 per barrel for oil is bad enough the prediction of Dr Shane Oliver, AMP Capital Investors chief economist and head of investment strategy, that oil is headed for US$200 per barrel in coming years is unlikely to be music to anyone’s ears, particularly as Oliver suggests stronger oil prices now pose a significant risk to the Australian and global economies.

Simply put Dr Oliver suggests as nations such as China and India industrialise they will use increasing amounts of energy, which will push up the oil price as without rising prices supply simply cannot keep up with the expected growth in demand. But blaming China for higher oil prices is simply mis-placed, as Oliver points out in per capita terms the Chinese use an average of two barrels of oil a year, compared to 15.5 barrels a year in Australia.

Fortunately his US$200 per barrel forecast is for the longer-term. Oliver takes the view in the next few months prices are likely to fall back to around US$100 per barrel as the current level cannot be justified by current supply and demand figures.

With increasing evidence global demand for oil is falling as the price rises Oliver sees the current price as being driven largely by speculation, supporting his expectation of a pullback. A further argument in favour of a fall in the oil price is the fact a number of countries such as Malaysia, India and Indonesia have recently increased petrol prices after having subsidised them for some time, with the likelihood the new higher prices will see a reduction in demand.

Even allowing for a correction in coming months Oliver notes higher oil prices are complicating economic policy both in Australia and overseas as it is adding to inflationary pressures, so forcing central banks to keep interest rates higher than they would be otherwise given slowing global growth.

While inflation is a growing problem the bigger issue in Oliver’s view is the fact higher oil prices act as an additional tax on consumers, reducing the level of spending and so pushing down corporate profits as it becomes harder for companies to pass on the cost impact of higher fuel prices.

This, even more than the US-led credit crunch and housing downturn, increases the risk of the global economy going into recession in his view, as world oil spending relative to global GDP is currently far higher than the levels that brought down global growth in the early 1980s.

Australia is in fact better placed to withstand this problem given higher oil prices are being matched by higher commodity prices and this is generating an improvement in national income, but from a consumer standpoint Oliver notes there is still an impact as higher petrol prices are coming at the same time as higher interest rates and this is squeezing household budgets.

Even being better placed is no guarantee a recession in Australia can be avoided, as Oliver estimates there is a 35% chance of such an outcome domestically against around a 40% chance for the world economy as a whole.

Strong oil prices are obviously good for energy shares, Oliver noting each US$10 per barrel increase adds around 15% in outperformance for this sector against the broader Australian market. The rest of the market suffers though from lower profit margins and this suggests a tough outlook in coming months in Oliver’s view, with Asian markets particularly at risk given a greater reliance on imported fuel throughout the region.

Any fallback in the oil price would therefore be a positive, so if it occurs as expected Oliver sees scope for an equity market rally leading into the end of the year.

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