John Collett, 17 February 2016

Usually cheap oil is good for the economy, but this time markets have reacted badly. John Collett gets to the bottom of it all.

The crash in oil prices is difficult to overstate. In fact, the price has fallen by so much, the barrels carrying the oil are now worth more than the oil they hold.

It’s a shift that has profound effects for everyone, not only in our investment portfolios but in our hip pockets as consumers as well.

The world’s economy is based on energy and the pricing of just about all sources of energy is linked to oil.

Crude oil prices have crashed through the floor. If they stay low, there will be implications for the Australian economy and consumers.

Some countries stand to benefit from cheap oil but for Australia, as an energy exporter, the implications of cheap oil are not clear cut.

However, there is no doubt consumers are winners. That is mainly through lower petrol prices, which also has some benefits for the economy.

Consumers have more to spend elsewhere and lower diesel prices lowers the costs of transport.

That helps keeps a lid on inflation. If inflation stays benign it makes it more likely that interest rates and mortgage rates stay low for longer.

A sharp rise in gas prices was in store for households, due to the ramping-up of Australia’s exports of liquefied natural gas to Asia, but this could now be tempered by cheaper oil.

Another possible benefit of cheap oil is lower air fares, because fuel costs are usually the single biggest costs of airlines.

Oil price crash

You have to go back to 2003 for the last time that oil prices were as low as current levels of just over $US30 a barrel.

Oil prices have been trending lower for most of the past 18 months. From 2010 to mid-2014, the oil price was stable at a little more than $US100 a barrel.

Most analysts think oil prices will stay low for some time yet.

Of the factors driving cheap oil, the biggest is oversupply.

Markets are being flooded with oil. Saudi Arabia, the world’s largest oil exporter, is cranking up supply to increase market share at a time when the United States is just about self-sufficient in oil and gas.

And Saudi Arabia’s nemesis, Iran, is increasing supply following the lifting of the embargo on Iran’s oil exports.

Slowing Chinese economic growth and reduced Chinese demand for oil is also playing a part.

Scott Haslem, the chief economist for Australasia at UBS, says: “We have inventory [of oil] continuing to build until the second half of this year.”

Even though demand is increasing, supply is growing more quickly. Haslem thinks it could rise to $US40 a barrel by the end of this year.

It could even rise to $US60 next year, he says. That is still a long way from $US100 oil.

Elio D’Amato, the chief executive of share analyst Lincoln Indicators, says: “There is no immediate catalyst for a sustained rally in oil.”

Cheap oil is probably the “new normal” for some time because of increasing supply and slowing growth in China and the emergence of alternative sources of energy, D’Amato says.

Many smaller oil producers in the US have filed for bankruptcy and the big producers are cutting their costs.

D’Amato says companies will either need to merge or they could “die”.

He says it is a period of change for the sector globally. “Only the strong will survive,” D’Amato says.

Low oil prices are a boon to countries that are net importers of oil, such as Japan and South Korea, and a disaster for countries which rely on oil exports for a large part of their national income, such as Russia.

For Australia, the impact of cheap oil is mixed.

Gas prices

Australia is on track to become one of the world’s biggest exporters of liquefied natural gas (LNG).

Natural gas is expected eventually to overtake iron ore as Australia’s No. 1 export.

The lower the oil price, the lower the LNG price.

That is because LNG contract prices are linked to the oil price. While that is bad for LNG producers, such as the Australian sharemarket-listed Santos and its shareholders, consumers are winners.

Domestic LNG prices were always going to rise as Australian domestic prices are lower than the world LNG price.

Analysts were expecting household gas bills to rise by 30 per cent over the next three years, as Australia’s exports of LNG to Asia ramp up.

Tony Wood, the energy program director at the Grattan Institute, says domestic gas prices will still rise, but it will not be by as much as if the oil price had remained high.

“It’s a good thing, as it helps to keep a lid on what would have otherwise been quite nasty gas price increases, Wood says.

Cheap oil is not expected to have an effect on domestic electricity prices.

About 75 per cent of Australia’s electricity production is from coal. The coal market is not that influenced by the oil price, Wood says.

“There is a link [with oil] but not a particularly strong one,” he says. “It is driven more by what the Chinese are doing in terms of their coal consumption,” Wood says.

Petrol and jet fuel

The most obvious benefit for consumers of a low oil price is through lower petrol prices.

Unleaded petrol prices, at about $1.10 a litre, are down from more than $1.40 in the middle of last year.

One of the reasons the falls in petrol prices have not been as big as the falls in oil prices is because about 50 cents of the price of each litre of unleaded petrol is government charges.

Still, filling up a car with 40 litres of unleaded petrol a week saves at least $12 each time.

Transport, particularly in a large country like Australia where so much is moved by road, is a big cost for many businesses. Lower transport costs helps keep inflation low, which means interest rates and mortgage rates are more likely to stay low for longer.

Chris Batchelor, general manager of online stock researcher Skaffold, says a lower oil price is generally a good thing for consumers and investors.

Consumers spend less on petrol and have more to spend on retail purchases and travel.

Lower oil prices should also mean lower jet fuel prices, as fuel is one of the biggest costs faced by airlines.

A big part of Qantas’ recent turnaround to profitability is due to low fuel prices.

However, travellers should not raise their expectations of cheaper flights too high.

Airlines often “hedge” their fuel prices for some time into the future so that they have certainty over their fuel costs.

Matthew Sherwood, head of investment market research at Perpetual Investments, says airlines will probably hold on to some of the fuel cost reductions to improve their margins.

“We can expect to see lower fares, but not anywhere near to what they are saving in fuel,” Sherwood says.


As for renewable sources of energy, the effect of cheap oil is likely to be minimal.

Wood does not think low oil prices will have much of an impact on the use of renewable sources of energy.

Australia has renewable energy targets. Policies are in place support and subsidise renewable energy.

About 7 per cent of electricity is from non-hydroelectric renewables. It is mainly from wind farms and the 1.5 million households with solar panels. A further 7 per cent is from hydroelectric power.

Wood says: “It’s hard to see how that would be affected in any way by the oil price.”

Any effect of the low oil price would be in regional Australia, he says.

For example, there are plans in some of the big mining towns to replace diesel electricity generation with solar, and those plans could be put on hold, he says.

Sharemarket volatility

As far as the sharemarket is concerned, the effects of cheap oil on producers are likely to keep outweighing the positive impact on consumers, says Shane Oliver, chief economist at AMP Capital Investors.

The shares of listed Australian companies that are directly exposed to the oil price have been hammered, with Santos, Woodside Petroleum and Origin Energy among the major casualties.

BHP Billiton announced a big write-down recently of its onshore US oil and gas assets, due to significantly weaker oil and gas prices.

However, rather than just taking flight from those companies directly exposed to oil prices, investors are selling shares across the board.

The share prices of our big banks have been in for a rough ride.

Local investors have, in part, followed what is happening overseas where the share prices of big banks in Europe and the US have been hit hard.

In the US, many smaller oil producers have gone to the wall and others are struggling. The big US banks who lend to them have made provisions to cover potential losses.

Local investors are also worried by how much extra capital our big banks may have to raise and whether they will be able to maintain their dividend payments.

The Australian sharemarket is likely to stay skittish, says Oliver.

However, at some point in the year ahead, it is likely we will see the boost to consumers and to economic growth will predominate over the negatives, he says.

He warns sharemarket investors against any knee-jerk reaction to falling share prices.

“The key for investors is to recognise that shares offer a higher return potential after sharp falls, selling after big declines just locks in a loss,” he says.

“Dividend income from a well diversified portfolio is little affected by share market volatility,” he says.

Analysts are also urging caution for those investors thinking of buying the vastly cheaper shares of energy companies in the hope of making a killing when the oil price recovers.

“Despite the falls in share prices, I can’t see any energy stocks that look like good buying opportunities at the moment,” Batchelor says.

D’Amato agrees that the risks are just too great. Even those investors prepared to take risks in the hope of finding a “turnaround” story need be extremely cautious.

“Only the brave would consider an investment in energy shares right now,” he says.

The better bets for investors are among the consumer discretionary shares – those that will benefit when consumers feel like they have more money to spend, D’Amato says.

These include JB Hi-Fi, Harvey Norman and Domino’s Pizza, he says.

Extracted in full from the Sydney Morning Herald.