Oil prices are still rising.
That’s forced the AMP’s Chief Economist, Dr Shane Oliver to take another look at the likely impact.
After a dip last week on the back of the tragedy in Japan the US West Texas Intermediate oil price is back above $US105 a barrel and Asian Tapis oil prices are around $US120 a barrel.
Increasing tensions in the Middle East and North Africa (MENA) have been the primary driver, with the US and various European countries now intervening militarily in Libya to enforce a no fly zone, along with escalating tensions in Bahrain, Yemen and Saudi Arabia.
The tensions between Sunni rulers and Shiites in Bahrain risk a further escalation, possibly drawing in Shiite dominated areas in Saudi Arabia and Shiite dominated Iran.
In addition, the lessening of the risk of a full blown nuclear meltdown in Japan has shifted the focus back to increased oil demand from Japan in order to make up for reduced nuclear power production and as part of rebuilding demand following the earthquake.
This is all occurring at a time when global demand for oil is rising on the back of the global economic recovery and a long term deterioration in the pace of new oil discoveries.
The rise in the oil prices is pushing up energy costs world wide. Australia is no exception, and the rise to date has pushed up local petrol prices to an average of around $1.45 a litre.
As can be seen in the next chart there is a pretty close relationship between the local petrol price and the world oil price in Australian dollars.
Roughly each $US10 a barrel rise in the world oil price translates to around an 8 cents a litre increase in Australian petrol prices.
If world oil prices stay at current levels expect petrol prices to rise another 3 to 5 cents over the next few weeks.
The war in Libya has affected most of its normal 1.8 million barrels per day of oil production.
Prior to the unrest in the Middle East, OPEC had 5 million barrels a day of spare oil capacity and so Saudi Arabia and other gulf states have been able to make up for lost Libyan production.
However, Libyan crude oil is light and cheaper to refine compared to the heavy Saudi oil grades, so this has added to the price of light oil grades such as Brent and Tapis.
Secondly, while OPEC can make up for lost Libyan production it, would only take a spreading of unrest and production disruptions to say Kuwait, Iran or part of Saudi Arabia to wipe out all of the spare capacity.
Finally, some suspect Saudi Arabia may be exaggerating its spare capacity. So it’s little wonder the oil price contains a risk premium, estimated to be around $US10-15 a barrel.
If the unrest spreads, a further increase in oil prices is likely.
While not experts on the Middle East, our sense is that, although the turmoil will continue to bubble on for a while, further significant oil supply disruption will be avoided.
As such the issue will become background noise for global investment markets.
However, as the risks are skewed towards more disruption and higher oil prices its worth considering at what level the surge in the oil price would create a problem for the economic outlook.
At what level will the oil price become a problem?
It’s true that past surges in world oil prices have preceded US recessions and sharp global downturns. See next chart.
However, other factors have also been involved – notably significant monetary tightening, and we are not seeing that now.
Much of the rise over the last two years has also been due to stronger demand with supply concerns only adding $US10-15 a barrel this year.
It’s also the change in the oil price that matters, not its level, as businesses and consumers gradually get used to higher oil prices.
Trouble normally ensues if the oil price doubles over 12 months.
We are not quite there yet.
Our assessment is that the world can probably live with oil around $US100 a barrel, and we expected it to reach that level this year anyway.
The following table estimates the impact on GDP growth of a $US10 rise in the price of oil for the year ahead in the second column and then applying that to the impact of oil at $US110 a barrel and $US140 a barrel.
Global growth this year is currently forecast to be around 4.3% by the IMF so if the world oil price settles around $US110 a barrel then global growth would be reduced by around 0.4% but would still be solid at around 3.9%.
However, a sustained spike to $US140 a barrel would be much more worrying as it would slice around 1.6% off world growth, 1.2% off US growth and 1% off Australian growth.
Asia is the most vulnerable, reflecting its heavy reliance on imported oil and its more intensive oil use.
Australia is less vulnerable as it is a net energy exporter.
The rise in the oil price will also boost inflation with roughly a $US10 a barrel rise adding 0.5% to inflation in the US and Australia and 0.7% to inflation in Asia.
What would central banks focus on – inflation or growth?
The European Central Bank is more likely to focus on headline inflation and so raise interest rates as it is threatening to do. However, the US Federal Reserve is likely to
