Why Rising Oil Prices Could Increase Interest Rates in Australia

The accepted wisdom around the economic traps right now is that interest rates will stay low for at least the next 24 months.

The consensus is that we’ll see two or three interest rate rises over the next two years.

At the same time oil prices will range between US$40 and US$60. Or so the forecasters tell us.

But what if they’re wrong?

And what have interest rates got to do with oil prices anyway?

I’ll explain that shortly. But first let’s look at oil. And the big reason long term forecasting this crucial commodity is so hard.

Just last week oil hit new six-week highs. And it was also the biggest weekly gain since July.

Moves like that get analysts interested. Robbie Fraser, commodity analyst at Shneider Electric, noted:

As Hurricane Harvey begins to fade as a short-term factor, the market is taking a closer a look at longer-term bullish developments on both the [Organization of the Petroleum Exporting Countries] and U.S. side of the market.

For OPEC, reports indicate a strong recovery for overall [production-cut] compliance levels in August…adding credibility moving forward. That has coupled with an increasing likelihood of a formal deal extension to support prices.

Read that statement carefully.

It tells you a home truth about the oil market. The truth of price manipulation.

This is not some stunning revelation I’m breaking. It’s an open secret.

But in case you didn’t know…

OPEC is the cartel of major oil producing nations. They have been working to fix the supply (and hence price) of oil for the last 50-odd years.

Saudi Arabia is the de-facto leader, and has the biggest and cheapest oil reserves of them all.

The Saudis in turn are close allies of the US. So, you’d expect the US government to also have some sway in this process, though to what degree is hard to know.

This is a manipulated market, make no mistake about that. And that’s why long-term forecasts are so hard to do.

The economics of supply and demand don’t necessary add up. Because the supply side of the equation is always up for negotiation.

It depends what’s in the best interests of the major players at a specific point in time.

Indeed, I remember when the economic consensus in 2005/06 was that $200 per barrel oil was just around the corner.

The term ‘peak oil’ was bandied about by all and sundry in reference to the supply of oil running out.

Google it for yourself and see the amount of stories out there about this ‘peak oil certainty’.

Then the GFC hit and oil prices fell from US$145 to US$35 per barrel, instead. Only to recover to US$125 in 2011

In 2014, inexplicably, the prices fell from US$100+ to US$30.

There was no recession, there was no crisis.

Maybe it was the intrusion of the US shale oil industry, but no analysts expected that to cut so deep.

The oil price went lower, and has remained historically low ever since.

If the analysts were so wrong on both these occasions, they could easily be wrong again on the US$60 cap forecast now.

What’s that got to do with interest rates, though?

Let me explain…

The link between oil prices and interest rates

Oil is the major energy source behind the economy. The price of oil has a run-on effect on everything that has to be transported or produced with energy.

It’s not just fuel.

It’s plastics. It’s chemicals. It’s even part of food production, by way of fertilizer.

It’s a base layer ingredient in most industries, to some degree.

This in turn increases the prices of goods and increases the rate of inflation.

Of course, a rise in oil prices might also be good for the employers in the Australian energy industry.

Offshore producers have been very quiet in Western Australia of late, with many big projects like Woodside’s [ASX:WPL] Browse project put on hold.

They need a sustained rise in oil prices to make these mega projects feasible. That would be good for the economy, and in turn for wage growth in Western Australia.

But as I said at the start, oil price rises also have a knock-on effect.

It’s on interest rates.

You see, the Reserve Bank of Australia looks to keep inflation within a medium-term band of 2–3%.

If oil prices go above US$60 and stay there, the flow on effects of higher prices and higher wages increases the rate of inflation.

If this effect is large enough the RBA will have to increase rates to keep a lid on inflation.

It’s a complicated puzzle for sure, and there are many other variables that could kick in.

But the relationship between interest rates and oil is clearly there.

If boom times return to mining and energy, we could possibly see a role reversal. With the Eastern states struggling under mortgage induced debt pressure, and the Western and Queensland economies beginning to ride high from better employment and wage conditions.

So, could oil prices really start to move sustainably higher?

Hedge your bets

Well our Head of Research, Greg Canavan, thinks they could. And because of the very fact it’s a manipulated market. You see, the Saudis are planning an IPO of their state oil company.

It’s due in 2018, and is going to be the biggest IPO in world history. Not the kind of thing you want to be a flop.

They are doing this in an effort to diversify their economy and assets way from just oil.

The value of the IPO and how much the Saudis will get from it depends on the price of oil.

Think about that for a moment.

The world’s largest oil supplier has a vested interest in higher oil price over the next 12 months.

Now, Greg isn’t some conspiracy theorist. It’s not paranoid to predict that OPEC will manipulate oil prices in their own favour. That’s the purpose of OPEC, after all. We’ve seen them do so many times in the past. And Greg he has found three companies he thinks will go up around 10 times their current value if this ‘oil price fix’ plays out.

And Greg has been around long enough to know he can be wrong as well. So, he has found the perfect way to trade this opportunity, and let the market tell him if he’s right or not.

With oil price hitting six-week highs, the trade signals could start flashing very soon.

If you’ve got a mortgage — or just looking for a big ‘off the radar’ opportunity — this could be the perfect hedge against oil-induced rising interest rates.

You can read more about it here.

Good Investing,

Ryan Dinse,
Editor, Money Morning

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

Money Morning Australia