Elements add up to oil price drop

The reporting season has kicked off with some cheery results from the likes of Bradken, WorleyParsons and United Group, setting a strong pace for the local profit season.

Results from APN News and Media, SingTel, Commonwealth Bank, Cochlear and Australian Agricultural Corporation were just on budget and thus not anything special, while perennial underperformer, Futuris, produced a shocker.

Briefcase thinks the over-riding mood of this market remains very cautious, but hopeful. All eyes are on outlook statements from management, who will have the advantage of drawing on information provided by their current order books and by gauging the health of their customers and clients to give guidance on the year ahead.

The other big item moving the share market is the oil price. If the price of oil looks like falling, the market cheers for the lower corporate costs it foretells and the lower inflationary outcome it supports, which in turn suggests lower interest rates and higher share valuation - all a roundabout way of getting to the answer.

When the oil price rises, the opposite factors come into play, with rising fuel costs squeezing corporate profits, lifting inflation and keeping pressure on central banks to leave interest rates high and thus making shares less attractive.

As always, a number of competing factors are affecting the oil price. The outbreak of war in Georgia - which is home to a leg of the Baku-Tbilisi-Ceyhan pipeline carrying an average 850,000 barrels of oil per day from the Caspian Sea to the Mediterranean - has not helped sentiment.

However, that pipeline was already shut down due to a fire on the Turkish portion last week and isn't expected to return to service for up to two weeks. Oil is being transported by rail in the meantime.

On the downside, the capture of Nigeria's senior rebel leader offers some hope for a cessation or at least reduction in disruption to oil production in that country, where at least 500,000 and up to 1 million barrels per day of potential oil production is estimated to be shut-in as a result of social and political unrest.

'Demand destruction' in the Western world is also going some way to balancing the market. Briefcase has previously outlined how modified driving behaviour in the US has led to a potential reduction of 600,000-700,000 barrels/day in that country alone, which would be about 3 per cent of daily consumption. Extrapolating this behaviour across the global market leads to the conclusion that demand destruction of up to 1.1 million barrels a day may have been occurring during the northern summer. It remains to be seen if this behaviour will persist as the cooler weather of autumn arrives and as the price of petrol subsides from recent peaks.

Economic weakness in Europe and North America will also negatively affect the consumption of oil by industry. Lower production of chemicals, plastics and building materials that rely on oil look like further reducing oil demand this year since the EU region appears to be in a period of negative economic growth.

Asian economic growth will result in continued expansion of demand for oil in that region, offsetting some of the lower demand outcomes resulting from higher priced oil.

Overall, Briefcase would not be surprised if oil and other liquid fuel consumption remained steady at around 86.7 million barrels a day during calendar 2008, leaving the market in short-term surplus.

In a healthy market, the price of any commodity is usually set by the marginal cost of production. Globally, most oil now has a cash operating cost of between $US10 and $US40 per barrel, with the marginal producers operating at around $US70/barrel.

Total costs are of course much higher, given a need to service both debt and equity while providing a reasonable return on capital spent. Most readers will understand that the oil market is not healthy, being riven with multiple non-market, social and political restraints while its major production block OPEC, runs a cartel designed to regulate the price of oil.

Given this background, predicting the oil price is a mug's game, but I'm game. In the short term, the oil price looks set to retreat towards $US100/barrel and could theoretically fall to $US70/barrel by late 2008, but this is unlikely with OPEC having its hands firmly on the spigots. In the longer term, Briefcase reiterates its view that the oil price will rise in real terms.

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Our pain monitor has kicked up a notch, indicating that we are still heading down into a trough of economic misery.

Futuris' subsidiary Elders has announced the loss of 100 jobs as it restructures this iconic rural supplies and services business. Unemployment in the US is now on a steadily rising trajectory, lifting from sub 4.5 per cent early in 2007 to more than 5.6 per cent. Meanwhile, Australia's Reserve Bank is predicting an economic slowdown so severe that 100,000 people will be thrown out of work in the next 12 months.

Former 'masters of the universe' and now unmasked, pea and thimble act players, Babcock & Brown, has warned that its interim profit will be down as much as 40 per cent this year, which will not add cheer to its management bonus pool.

Briefcase expects that, by December, this torrent of bad news will peak and prior to that moment, the stock market will have found a base. The big unknowns remain with hidden horrors in the US's economy, where an absolute mismanagement of automobile leasing is likely to inflict much more pain on lenders before we see the end of the current bear market.

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In currency moves, the Australian dollar has retreated about 12 US cents, or 12.2 per cent, during the past couple of weeks against a resurgent US dollar, which has risen 4 per cent against the yen and the British pound. On the flip side, the AUD has retreaded just 4 per cent against the pound and 8 per cent against the yen.

Falling commodity prices, most notably gold, nickel and oil, should be kept in context with the rising US dollar. For instance, while the gold price has fallen about $US159 per ounce or 16.2 per cent from a high of around $US980/oz in mid July, in Australian dollar terms it is down about $A71/oz or just 7.1 per cent from its high of $A1,000/oz over the same period.

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The current iron ore bubble in Australia is bound to end in tears. Iron is about the most abundant element on the earth's crust. Deposits of iron mineralisation are not rare - they can be found everywhere. Up until 2002, the price of iron ore in a ship was about $30 per tonne, leaving little margin for most producers. No wonder that there were few new deposits developed in the 1990s, leading to a current shortage of the stuff. Enter China, which over the past seven years has come from nowhere to now account for about half of the world's total 820 million tonnes annual seaborn trade in iron ore.

Some new producers are gearing up to deliver product at $60/tonne, while others are selling product that would not have made it to the ship in recent years. Given that prevailing prices range between $80 and $125/t of ore, depending on grade and quality, some of these newcomers may make a bob, even after capital costs, which have more than doubled over the past four years.

The big worry is a stumble in China. There is no doubt that China will continue to grow over the long term, but there is also no doubt that along the way, the Chinese economy will stumble and experience a year or two of steady or even contraction of demand. When this happens, prices will fall dramatically, high-cost and low-grade producers will fail and the market will correct to a less frantic pace.

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- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au