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Analyst report
Should you worry about higher oil?
March 26, 2008
Brendon Lau, ShareAnalysis
Every time crude oil hits a new record high, it seems to send shivers through the markets (outside the energy sector), as investors fret about how high crude prices could feed the burgeoning global inflation problem. But are these fears misplaced?
Some economists would say yes. After all, several central banks around the world tend to strip out food and energy costs when measuring inflation. This practice is based on the belief that volatile food and energy prices will distort the "real" price measure. One only needs to remember what happened to Australian banana prices to make this connection.
Others would also argue that oil dependency in industrialised nations has actually fallen, and that means crude prices are becoming increasingly less relevant to the CPI reading. In the US, the Energy Information Agency (EIA) reported that total energy expenditure (as a proportion of US GDP) has fallen dramatically over the last 30 years. Furthermore, petroleum's slice of the total energy pie has shrunk by more than half over the same period.
Here in Australia the trend is similar; petroleum as a proportion of total energy has shrunk. According to the Australian Bureau of Statistics (ABS), total energy consumption has jumped over 67% from 1975 to 2001 but petroleum has increased by less than 20%.
While these arguments may be true, the reality is that oil prices have stayed high for an extended period. Unlike bananas, the crude oil price has been steadily climbing for about nine years now, and it appears unable to fall back to long-term historical averages. Before the turn of the century, crude prices were hovering just above US$10/barrel.
In fact it is the longer-term downstream impact of high crude prices that are the real worry, as prices of other materials like chemicals, rubber and plastics have jumped. But quantifying the effects of higher crude prices is difficult. The Bank of England estimated that a US$3-4 rise in crude would add 0.1% to UK CPI after two years. No big deal, right? But the flow-on effect would add a further 0.3% to 0.4% to the core CPI after the two-year period.
Adding to the argument that investors should be worried about crude prices is a study by the EIA, which shows that the global crude price has broadly tracked US CPI since the 1970s. But that is the US. In Australia, our CPI (core and headline) does not show much statistical connection with that of the US, especially in more recent times.
This is partly due to exchange rate movements as a stronger Australian dollar has helped offset higher commodities costs. However, investors should not count on the strong Australian dollar for more respite as gains in our currency have failed to match crude's phenomenal rise, and are unlikely to do so. There is also anecdotal evidence showing the impact of high crude prices on our core CPI, judging from the outlook statements of Australian listed companies across almost every sector.
Volatile crude prices have another unintended impact. As businesses base a number of investment decisions on fuel-price expectations, firms could make inefficient decisions due to the volatility or hold off investing completely. The same could be said for consumers. The high crude price is making life more uncomfortable, but the volatility is an unwelcome additional burden to our economy.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this edition of CompareShares:
Investing: Defensive stocks that analysts are targeting
Trading: Random trades lead to random results
Sectors: Analyst puts buys on two energy stocks
Commodities: Should you worry about higher oil?
Advisor Lounge: Rent out your home without paying tax
Markets: Now central banks are buying investment banks?
Commodities: Opportunities arise from gold price plunge
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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