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Oil Price Harms Australia's Economy
Charlie Nelson
director foreseechange
February 2003
The recent rapid rise in oil prices, and possible future increases, will slow growth in several sectors of the economy. These include retail sales, new vehicle sales, and dwelling investment. Furthermore, rising oil prices impact consumer price inflation both directly and indirectly through increasing the cost of transportation and the cost of food production. Motor fuel and food, whose prices are rising due to drought, are frequently purchased commodities and could quickly influence inflation expectations. As the Reserve Bank of Australia (RBA) primarily targets consumer price inflation, a sustained increase in oil prices could force an increase in interest rates, further slowing the economy.
The economy slowed dramatically in late 2000 under the combined pressure of rapidly rising motor fuel prices, rising interest rates, and post-GST uncertainty. Similarly, the last recession in 1991 was caused by the RBA hiking interest rates too high combined with rising motor fuel prices resulting from the Gulf War in 1990.
While consumer spending is likely to continue to support economic growth in Australia, a sustained rise in motor fuel prices combined with a miscalculation by the RBA, or an extension of the drought, could slow discretionary spending dramatically.
When the Australian Bureau of Statistics conducted the last Household Expenditure Survey in 1998/99 (based on 6,893 households), they found that weekly spending on motor fuel and lubricants averaged $26.43 per household per week. This represented 3.8% of average spending on all goods and services and 3.0% of average income. Between the March 1999 quarter and the December 2002 quarter, the price of motor fuel has increased by 36.2% while the overall consumer price index has increased by 14.5%.
Most spending on motor fuel is not discretionary and research by foreseechange has found that for every 10% rise in the price of motor fuel:
Retail sales growth is reduced by 1.0%;
New motor vehicle sales growth is reduced by 3.0%;
Dwelling approvals growth is reduced by 2.6%.
Rapidly rising fuel prices slow growth in consumer spending on consumables, durables, and housing investment - by reducing discretionary cash flow and reducing willingness to borrow.
Rapidly rising fuel prices also cause the overall consumer price index to increase more quickly. Research by foreseechange has found that a 10% rise in the price of motor fuel will boost the consumer price index by 0.5%.
There are various scenarios concerning the future of oil prices. In the short-term, the price of oil could be anywhere in the range $US10 per barrel to $US80 per barrel (the current price is about $US37 per barrel). The low end of this range could be achieved if the Iraq situation is quickly resolved in a manner favourable to the USA and if there are no further disruptions in Venezuela. The high end of this range could occur if there is a protracted war in Iraq and supply problems elsewhere.
The impact of oil prices towards the high end of the range, would be to push up pump prices by as much as 50%, and the economic results would be:
Retail sales growth being 5% less than otherwise;
New vehicle sales being 15% less than otherwise;
Dwelling approvals being 13% less than otherwise;
Consumer prices being 2.5% higher than otherwise
But oil prices may be permanently on the way up. Currently global demand for oil is rising at 2% per year. The Energy Information Administration forecasts that worldwide demand for oil will increase 60% to the year 2020 (Campbell and Laherrere, The End of Cheap Oil, Scientific American March 1998). From an economic perspective, when the world runs out of oil is not directly relevant, what matters is when production begins to taper off, at which point prices will rise unless there is a commensurate decline in demand. Opinions on when this will occur vary. Optimistic estimates are that oil production will begin tapering off by 2020, Campbell and Laherre’s estimate is around 2010 (Campbell and Laherrere, The End of Cheap Oil, Scientific American March 1998). This Princeton University geologist Kenneth Deffeyes is also predicting that world oil production will probably peak before 2010 and then decline, triggering higher energy prices and global economic disturbance. CSIRO research is challenging more optimistic interpretations of oil-industry data and predicting that the world’s rate of production of petroleum will begin its terminal decline within the next 5 years (The Big Rollover, 2001, p1).
Given that interest rates rose by 0.5% in mid-2002 and the long lags between rate rises and their full impact on the economy, interest rate decisions by the RBA in 2003 and 2004 could have profound consequences, depending on the unpredictable future of oil prices. Other hard to predict influences on consumer prices and the economy include the rate of recovery from drought and the value of the Australian dollar. The margin for error in setting interest rates is currently very slim.
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