Global equity markets have had a good run since mid-May. Global growth has picked up, inflation is quite well-behaved and long-term interest rates are low by historical standards. The Bank of England cut its base rate to 4.5% from 4.75%, while the Reserve Bank of Australia has hinted at no action for quite some time to come. All this should mean continued good performance of equities markets.
However, it is important to take stock. One thing that has not relented is the price of crude oil?now nearly $66 per barrel. Yet, equity markets on the whole remain unfazed. There are sound arguments to suggest that the developed world has become relatively immune to rising energy costs. For one, economic growth in the US has not suffered in the last two years. Even the Japanese economy, wholly dependent on crude imports, is showing ample signs of life. Emerging markets and Asian economies, in particular, have held up rather well, despite rising inflation prompted by energy costs.
This has caused many to dismiss the rising price of crude oil as merely a nuisance. That may be a dangerous folly. That it has not had any apparent effect on global economic activity doesn?t mean that it would cease to matter forever. The truth is that we do not know the tipping point, except in hindsight. It would be entirely reasonable to state that with every dollar rise in the price of crude oil, we get closer to, and not farther away from, that tipping point.
However, to reiterate, it need not necessarily end this way. There would be room for optimism if more governments decide to pass on their higher energy bill to their consumers. If only the US government added an energy conservation tax and allowed the prices of gasoline to rise, not only would it keep more of the spending by its population, instead of sending it to OPEC governments, it would also allow the price of energy products to drop significantly. Thailand has removed diesel subsidies. This might have temporarily sent the consumer pri-ce inflation rate soaring, but it would also surely help to restrain aggregate demand in the economy, as it responds to the price signal. Indonesia swallowed the bitter pill, but only partially, in March. Unfortunately, it has postponed another price increase to January, fearing popular backlash.
In this regard, the pusillanimity shown by the Indian government in raising the prices of petroleum products causes deep concern. It has not only raised the possibility of immiserising its oil companies, it also does not allow the consuming pubic to make informed decisions on energy consumption. That administered prices have been decontrolled has no meaning, given the government?s tight grip over price-setting. What the country needs is a comprehensive energy policy, with accent on alternative energy sources, dovetailed with a policy on public transportation. The hydrocarbon-based development model has clear economic, social and environmental costs. India might pay dearly for this foot-dragging by the government. However, globally, as prices are passed on, demand would naturally slow down in response to higher prices. Last, and perhaps equally important, it stores considerable fiscal pressure on the government, particularly since the finance minister has his finger already on the ?pause? button on fiscal consolidation. Indian macro-economic policy is clearly flirting with, nay courting, danger.
However, a mild reprieve might yet be possible. Some of the recent run-up in the price of crude oil is directly related to near-term events. The announcement of the Saudi king?s death, terror warnings in Saudi Arabia and the closure of the American embassies in two Saudi cities, recent resurgence of bombing attacks and shut-downs in refineries have been the near-term triggers. Some should dissipate over time. Others may not.
The probabilities of these two scenarios?one where the price of crude oil continues to surge, exceeds the invisible tipping point and thus brings the global economy to heel, and the other whereby it falls, substantially offsetting the removing of policy stimulus and fading of asset price booms?are finely balanced. For now, we go with the latter view, that oil prices would fall, for no reason other than that it has been going in one direction for three years, particularly in the face of rising inventories of crude oil and petroleum products in consuming countries. The breakdown in the relationship between crude inventories and the price of oil suggests a role for speculation in the price surge.
Indeed, in the past five years, OECD demand for petroleum products has oscillated around 48 million barrels per day, the average for the past five years too. Current demand is not different from the five-year average. Non-OECD consumption is around 34 million barrels per day, which is about 10% higher than the five-year average of around 30 million barrels per day. Yet, the price of light sweet crude oil is 100% above the five-year average of around $33 million barrels per day. Clearly, there are grounds to believe the price action has been excessive, unless the market prices in the risk of OPEC running out of oil soon. If so, the world is short of relevant information to make appropriate energy choices.
In sum, there are reasons to believe the current frenzy in the crude oil market would abate. If they do not, in time, the world economy comes closer to the tipping point and growth realisation in 2006 might be drastically lower. Whichever financial market shows no cognisance of such risks in price action would be the most vulnerable, particularly since the effects would be compounded by injudicious government (in) action. India figures on top of that list.
The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views
