Economy will feel heat sooner rather than later

By BRIAN FALLOW

After trucking along for five years, our economy has hit an oil slick.

World oil prices reached US$45 ($69) in New York this week, their highest in 21 years and roughly twice their average over the past 10 years.

Diesel prices at the pump are up 19c a litre or 31 per cent higher than they were six months ago. Petrol is up 16c a litre.

"It's a bit scary ... Prices are the highest we have seen in a long time," says Don Braid, managing director of New Zealand's largest trucking firm, Mainfreight.

But not scary for Mainfreight itself.

"We obviously pass that through to our owner-drivers. And any surcharge we pass on is then passed on to the customer. We have got a fuel surcharge now of 2.8 per cent on the freight cost and we would expect that to rise again to the vicinity of 3.5 per cent if this US$45 oil holds."

This time last year, the surcharge was less than 0.5 per cent.

Dean Bracewell, managing director of the Freightways courier company, has the same problem and the same solution - pass it on.

"We don't like passing costs on but fuel prices are exceptionally high. They haven't been this high since late 2000 [when the dollar was weak], and when any cost goes to exceptional levels, yes, we do pass it on."

Tony Friedlander, Road Transport Forum chief executive, believes trucking firms' rates will rise between 5 and 10 per cent. "Our surveys say most trucking companies are operating at margins below 5 per cent on turnover, so they simply can't absorb it."

None of this bodes well for consumers, or for borrowers as Reserve Bank Governor Alan Bollard struggles to keep a lid on inflation.

The trucking firms are just one link in a chain that stretches back to oil exporters enjoying the mother of all sellers' markets.

World demand for oil has been climbing steeply.

The International Energy Agency estimates it will rise 3.2 per cent this year.

That equates to 2.5 million barrels a day, or more than the British sector of the North Sea produces. It is roughly three times as fast as the average annual increase between 1998 and 2002.

The IEA expects demand to grow by a further 2.2 per cent next year.

This reflects a buoyant world economy and, in particular, a booming and increasingly motorised China, where demand has increased 27 per cent during the past two years.

The result is a world market with little spare capacity, so threats to disrupt supply from a major producer such as Iraq have a big effect on prices. Last month, Iraq pumped 2 million barrels a day or 2.4 per cent of world output.

The IEA estimates Opec's spare capacity at 1.2 million barrels a day, but only some of that is sustainable without further drilling or other work.

Although international oil prices are back at early 1980s levels in nominal terms, when adjusted for inflation they are still well below the levels in that era of stalled growth and rampant inflation.

But they still hurt. A study by the investment bank UBS suggests that if the US$45 price is sustained, it would reduce world GDP by 0.4 per cent next year and 0.8 per cent in 2006.

And the IEA estimates that a US$10-a-barrel price increase would cut world output the following year by about 0.5 per cent.

That might not sound like much, but it is equivalent to turning off three economies the size of New Zealand.

As a general rule, the New Zealand economy is sensitive to what happens to the world economy.

But a harder time for exporters is only one of the channels through which a world oil shock is felt here.

The more it costs people to fill up their tanks, the less they have to spend on other things. Westpac economist Nick Tuffley estimates that the 15 per cent increase in petrol prices since December would cost the average household an extra $4 a week.

But unlike an interest rate rise, say, or a tax increase, most of that money leaves the country.

The result would be weaker growth. Westpac estimated that if the recent increase in global oil prices was sustained, it would cut New Zealand GDP by between 0.4 and 0.6 per cent.

Consumer petrol prices rose 7.8 per cent in the June quarter, says Statistics New Zealand, to be 19 per cent higher than a year earlier.

But the inflationary impact does not end there. Higher fuel prices also raise the cost of everything that is transported.

If firms feel able to pass on those costs to their customers without too much risk of losing business or market share, and if they compensate employees for a higher cost of living confident that they can pass those costs on too, the result is an inflationary spiral of exactly the kind the Reserve Bank has to resist with the only weapon it has - higher interest rates.

With the economy having expanded by nearly 22 per cent during the past five years, its resources are at full stretch and inflationary pressures are mounting.

On the one hand, this means Bollard might welcome a slowing in growth because of higher oil prices. It would count in the balance against the need for more interest rate rises.

But he also has to worry about the risk of a pass-it-on inflationary spiral becoming entrenched, something more likely in an environment like the present one in which business is good and labour is scarce.

It is also more likely if higher oil prices persist.

"It's like when the currency is sliding," says Tuffley. "People will tend to absorb it for a while, but the longer it remains low, putting pressure on margins, the shorter their patience gets."

The danger, he says, is that the effect of oil prices on growth will coincide with the expected slowdown as the housing boom fades.

The Reserve Bank's June monetary policy statement, citing international consensus forecasts in May, assumed that oil prices would fall towards US$30 a barrel by the middle of next year.

Even with that assumption, the bank expected economic growth to slow to below 2 per cent by the year to March 2006 and inflation to spend next year above 3 per cent.

But the risk is mounting that the oil price graph will look more like Ayers Rock than Rangitoto.