Caton's Corner - March 2011

The biggest positive for markets is the continuing global economic recovery. The US economy, in particular, continues to surprise on the upside. In the past two months, for example, the unemployment rate has fallen by 0.8 percentage point. While some of this may be statistical noise, this is the fastest two-month decline for more than 50 years.

The negatives just won’t go away, however. The unrest in North Africa goes on, with Libya the highest-profile trouble spot at the moment. In particular, oil exports from that country have dried up, and the world oil price has risen significantly. The North Sea Brent oil price is currently US$113, its first time over $100 since September 2008. The Tapis oil price has also risen, and this will flow on to higher pump prices in Australia (see more below).

Financial markets fret when oil prices rise, particularly when there is uncertainty as to how much higher they could go. It is worthwhile pointing out that Libya produces less than 2% of the global oil supply, although its oil is of very high quality. Any shortfall from Libya can easily be replaced in the short run by greater supply from Saudi Arabia. The concern is, of course, that the unrest spreads to other large producers. While one cannot rule out a worsening outcome, my suspicion is that disruption will not be too great, in which case markets have probably already over-reacted.

That’s not to say that the oil price must fall back to where it was a month ago. What’s also important right now is that the demand for oil has risen sharply, mainly because of strong growth in the developing world. Remarkably, to take just one example, industrial production has doubled in developing Asia in the past six years, while it has shown hardly any net growth in the major developed nations. This strong growth has also had an effect on other commodity prices, particularly food. The chart shows 110 years of food prices, adjusted for overall inflation. As can be seen, there is no clear trend, but the past 40 years have been very interesting; food got dramatically cheaper for 30 years, but has become much more expensive in the past decade.

The other place where the “developing world growth” story has had a major impact is on hard commodity prices which, in the case of Australia, means coal and iron ore. Australia has benefitted hugely from the rise in prices in recent years, and mining investment is set to be the major growth story for the Australian economy in the next two years at least. But RBA Governor Glenn Stevens reminded us in February that the history of commodity prices has a very clear lesson: what goes up must come down. While demand for our commodities appears likely to be strong for decades, supply elsewhere will respond to the higher level of prices. The trend in commodity prices may be up, but at some stage there will be a significant fall. Australia would do well to “bank” some of the abnormal returns in the good years.

Higher prices at the pump?

While we’re on the topic of the domestic economy, the question arises: what difference does the oil price rise make to the Australian consumer? A $10 per barrel increase translates into an extra 6 cents per litre, but let’s assume that the average pump price rises by about 10 cents (about 7-8%). Petrol is about 4% of the CPI, so the latter would thus be raised by about 0.3% (this is the direct effect; there may also be smaller indirect effects). This is not exactly a “game-changer”; the pump price would remain significantly below its 2008 peak.

The energy-intensity of GDP in the developed world is less than half what it was in the 1970s, so developed economies are less vulnerable to energy price rises than they used to be. That said, the ration of petroleum imports to GDP in the US is as high now as it was at the time of OPEC I and OPEC II, simply because domestic production of oil has not kept pace. It is generally thought that a sustained $10 increase per barrel may shave 0.4 percentage point off GDP in the developed world over a two-year period. In a world that is in solid recovery, this may not be noticeable. In any such exercise, one has also to remember that there are always winners. Oil exporters are richer, and may well spend some of their gains, to the benefit of those who export to them. Similarly, energy shares are likely to outperform.

A carbon tax

The other major development of the month has been the announcement by the Government of its intention to impose a carbon tax (or is it a price?) in mid-2012, with the tax being converted to a full-blown emissions trading system some years later. There is not enough space to deal completely with this issue. Suffice it to say that, despite the short-term cost, such a move is necessary if one acknowledges the long-term effects of doing nothing. Even if the tax were fully compensated, so the average household experiences higher energy costs but no overall loss of purchasing power, the introduction will be disruptive. Recall that when the GST was introduced, the overall burden of taxes did not rise. Income taxes fell by more than spending taxes rose. Nevertheless, there was a short, sharp interruption to economic growth, simply because the “rules of the game” had been changed. Expect a similar effect when the carbon price is introduced. Recall, also that there will be winners, in particular any firm with a “clean” technology should benefit.

Chris Caton
Chief Economist