Rita, Katrina, Oil and the Economy

David Roffey is a Webdiary columnist and Webdiary's General Manager. David Roffey's SMH Webdiary archive is here.

by David Roffey

Every year some friends engage in a round of predictions for the year to come. My own contribution, on 2 January this year, had this to say about the economy - most of the group are in the UK, hence their concentration on UK interest rates and house prices, but you could substitute Australia for the UK without much change:

Economy: well, it all depends on the US (UK politicians have only marginal input to interest rate outcomes). US Treasury bond futures still indicating that US rates will go up another 1-2% over the year, which isn’t big enough to HAVE to play out into other people’s rates BUT ...

1: The US twin budget and trade deficits will continue to balloon – 1) any action to stop that will certainly bring a worldwide recession (instead of only maybe if they don’t), and 2) God has told GWB to make his daft tax cuts permanent.

2: That will tend to keep the trends going as they have since the re-election, ie stock market up (in the US anyway) and US dollar down. The Chinese won’t take the yuan/renminbi peg off, so the dollar devaluation won’t make any big difference to US imports, except to transfer yet more of it to Asia from Europe. The consequent slowdown in the European (inc UK) economies MIGHT be enough for the Eurozone to abandon the “stability pact”, thus meaning that Euro interest rates might actually come down, meaning even less upward pressure on sterling rates. Expect the $2 Euro and the $3 pound by year end.

3: The Japanese and Chinese will start quietly putting some of the profits from US trade into Euros, which will begin to push US rates up by much more than that 2% mentioned above.

4: At some point a tipping point will come in US consumer confidence, and people will start saving and reducing debt (same thing for economic purposes). When it comes, stock markets and US house prices will go into free fall. It might not be in 2005, but (this being economics, not rationality) it will happen as soon as enough people believe it is going to happen in the future. Once it happens all bets are off.

5: My stock market prediction for end 2005 is therefore FTSE at 5500 if the tipping point isn’t reached and 3000 or less if it is: could be either: invest for the former but keep your broker’s number handy for selling everything before the market opens if the Dow falls more than 300 overnight.

6: UK house prices will be somewhere in the same region as they are now, say 10% either way.

Those perennial optimists who were saying 6 months ago that there was no way that the oil price could go up to $40 a barrel will soon be celebrating the fact that it has settled at a stable rate of around $42-45. By June, big oil companies will start major investments in alternative energy (by big I mean billions of dollars). This has complex interactions with the “tipping point” problem that make my head hurt. Longer term this is all to the good, though a $60 or even a $100 barrel (say £1.50 a litre at the pump) would be better.

Now, clearly I was wrong about some of this - the oil price didn't stabilise at $42-5 for long for example - but the question posed today around that group is: is point 5 above now imminent? And if so, what would be the trigger?

Commentators at the positive end had already started writing their "why the world economy survived Katrina" pieces within a week or so of the disaster. The (economic) question is - will US consumer confidence (and market confidence generally) survive Rita? I leave for others the shorter term questions around whether the US authorities learned enough from the Katrina debacle to ensure that far more Americans personally survive Rita. As I write, Texans are evacuating.

A second Cat. 4/5 storm in the Gulf within a few days is a very different thing for public sentiment to cope with than a single, not unprecedented event - two Cat 4 storms in a year last happened in 1915, when 275 died in Louisiana when Lake Pontchartrain broke its banks and 275 in Galveston, Texas a little later ... Note that storms L-Q have passed by already in the last few weeks - Maria, Nate, Ophelia and Philippe all reached hurricane strength, but all stayed in the Atlantic (Ophelia hit Nova Scotia: ). Even if, as we all hope, Rita passes or fades without the dramas and human suffering of Katrina, the fact that it existed at all is going to change how people feel, and potentially push them toward saving for a rainy day rather than spending. That will at least take the world economic foot off the accelerator, and may slide it toward the brake.

Oil

As Rita reaches Cat 5 and roars across the Gulf of Mexico, it is all but certain that, even if a miracle happens and it fades before reaching the coast, it will compound the damage to offshore oil facilities in the Gulf. Many platforms were severely damaged by Katrina but survived - will Rita push them over the edge? If Rita does reach land, it will certainly add to the damage to refinery and distribution infrastructures in the US south. Many commentators have pointed out that refinery capacity is more of a contraint on oil supplies than is the rate of production.

So, almost certain increased damage to oil platforms, and possible increased damage to refining. What is the world's capacity to react? This week's OPEC (temporary) increase of 2 million barrels per day (mbd) is essentially irrelevant. OPEC nominal quotas total 28mbd, but according to the IEA, OPEC has been pumping more than 29mbd for the last year, and in practice they are at capacity for light crude production, though the Saudis could increase pumping on some heavy sulphurous stuff that no-one wants. They have been running close to flat out to try to keep prices stable. The only OPEC country with substantial spare capacity is Iraq, and maybe now that peace has returned there to the point where British soldiers feel able to demolish a jail and release 140 insurgents, that can be brought on-stream? Even if Iraq stabilises further, it is uncertain how much work and time is needed to restore all its production facilities.

In fact, again from the IEA estimates (Monthly Oil Market Report dated 11 August 2005), world demand for oil at 83.3mbd was already running up toward supply at 84.5mbd. The IEA predicts demand will reach nearly 86mbd next quarter, and 87.6mbd in Q42006. Release of reserves as agreed post-Katrina could perhaps have kept the lid on the price a while longer, but Rita may blow the steam vent off the pressure cooker. Mad e-mail-distributed boycott schemes will have zip impact on this.

As it is, oil futures prices have persistently been predicting ongoing rises for the last few months, as the price for future delivery has been above the spot price. This state, known by the wonderful name of contango, is normally seen as implying that the forward price will fall to the spot price, but the persistence of this effect suggests that the opposite is more likely. I've found it more interesting watching the longer term prices here, which have been pretty steadily trending up. Oil for delivery in 2011 is currently trading at above $60 - it isn't traded much, but it hasn't fallen as much as the spot price when it falls, and relatively goes up a bit more than it falls in each cycle. In sum: the market doesn't think the price is going to fall significantly any time soon.

Back to Rita: what impact will it have on oil prices? Hard to say, but it isn't going to be downward.

The economy

High resource prices have been good for the ASX most of this year, but the ASX isn't the economy, and not many of us gain from (or work for) those gains. The impact on the rest of us is at best mixed, and will certainly be negative if the steam goes out of US spending. Commentators have been making sure to get their caveats in so that if this happens they can say "we told you so", though they've mostly been buried at the end of rosier pieces under an exculpatory "of course ..." that is the equivalent of a knowing wink and a smile that says "but don't worry". Notable more cautious exceptions from Alan Kohler and Ross Gittins recently. [Sadly, the Alan Kohler piece A therapeutic shock to the global system is now 8 days old, so will cost you $2.20 from Fairfax]

Doomsayers have been wrong too often to be worth adding to the literature now - but just because some have been saying "the end is nigh" for a while doesn't mean that it isn't on its way, just that it isn't here yet. Will this weekend be it (or at least the tipping point that starts it)? Right now I'd say more likely than not, but the market is sentiment not rationality, and sentiment has kept reality out for a long time already. There is a lot more that could be said here, but this is the Web, you can find it all said elsewhere - more importantly, what do you lot think?

Disclosure note: the author sold all his shares that weren't bound up in option schemes in 1998, when the FTSE was 5750: this means he lost out on the last 10% of the rise into 1999, but the FTSE closed last night at 5370 - and some of those shares fell a lot more than that and got replaced in the index by others. You will spot that he's been predicting this for a while, and put his money where his mouth is - also that he didn't lose out at all by being premature!

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