The most significant impacts of the oil crisis are yet to come

Higher costs and potential economic slowdown are on the horizon. For business leaders, the key challenge will be navigating uncertainty while keeping costs down.

The oil markets are in absolute chaos.

From one day (or one hour) to the next, the Strait of Hormuz is either open or closed.

While getting accurate information is adding to the complexity of the situation, one thing is clear; ships can’t get through one of the world’s most critical energy chokepoints.

Oil markets have reacted sharply with the price of oil climbing from around $US60 per barrel to above $US100.

However, this initial spike is not purely from supply shortages, which is why the worst impacts may still be yet to come.

The key drivers behind oil prices

Oil prices aren’t driven by supply and the demand from economic activity alone.

Two other less visible forces on the demand side, speculation and precaution, play an important role.

Financial traders buy oil futures to profit from anticipated price increases. At the same time, businesses that are reliant on oil such as refineries and logistics firms purchase futures contracts to hedge against uncertainty.

These two forces can push prices up rapidly before any actual supply shortage occurs.

In other words, markets move first, and the effects of any physical supply disruptions come later.

Oil transportation is slow, meaning it can take weeks for shipments to reach global markets, including Australia.

Because many shipments were already in transit when disruptions in the Middle East began, the full supply shock has yet to materialise.

Australia’s vulnerability to the oil crisis

While the Federal Government’s cut to the fuel excise has provided relief at our petrol pumps, Australia is particularly exposed to global fuel shocks.

Despite being resource rich, Australia is a net importer of oil, with only around 12 per cent of refinery feedstock domestically produced, leaving us dependent on international supply chains.

Businesses, especially those dependent on transport and logistics, face rapidly escalating costs.

And without hedging mechanisms in place, companies are left to absorb these costs that are beginning to flow through supply chains.

The solution for businesses is to either absorb lower profit margins, raise their prices, delay investments, reduce activity, or cut labour costs.

The Fair Work Commission passed an order earlier this month, requiring fuel price changes to be reflected in transport rates.

This order is designed to provide truck drivers and road transport businesses with greater flexibility in managing fuel price changes, so these costs can be passed along the chain.

The chain includes supermarkets, retailers, manufacturers, and other businesses that contract road transport services and logistics companies.

Economists look at these impacts in ‘orders’. The ‘first-order’ effects are higher fuel costs for both households and businesses. The ‘Second-order’ effects are businesses pass on these costs to customers through higher prices. And the ‘Third-order’ effects are reduced economic activity, project cancellations, and potential job cuts.

The flow on effects will see prices rise at supermarkets and retailers as contracts are renegotiated with transport providers. Travel costs, including flights, are also increasing due to higher jet fuel prices.

What is the solution?

Governments have few tools to address what is fundamentally a supply-side problem.

The Federal government has already halved the fuel excise providing short-term relief to consumers.

However, this doesn’t address the cause of the crisis and fix supply in the short term.

Policymakers are currently focused on securing fuel supplies through international agreements including increasing supplies from the U.S, Argentina and Algeria.

As inflation increases, the Reserve Bank faces a classic dilemma of raising interest rates to curb inflation while risking slowing down our economic growth.

This creates the possibility of stagflation, which is a combination of high inflation and weak economic activity. The last time we faced a similar situation was during the oil crises of the 1970s, which ultimately led to a recession.

While the government may renew discussions about investing in domestic refining capacity to make us less reliant on imports, these solutions take years not months to implement.

What are the upsides?

All of this doesn’t sound very promising for the Australian economy.

However, there are a few potential upsides.

This week the UAE, the world’s eighth largest oil producer, announced it will leave the Organization of the Petroleum Exporting Countries (OPEC).

OPEC members produce around half of the world’s oil exports, and OPEC has the power to influence oil price with coordinated changes in production. OPEC announcements have also historically moved the price even before supply changes.

If the UAE increases production, it would mean lower oil prices and Australians could see some relief at the pump. Businesses could also face lower freight and transport costs. However, price relief is unlikely in the short term due to the Strait being closed.

The Australian dollar has strengthened, due to a combination of factors including the RBA’s higher interest rates making Australia more attractive to foreign capital investment, a weakening US dollar, strong demand for our exports (such as iron ore, coal, and liquefied natural gas (LNG)) and rising demand for green energy materials like lithium and copper.

The strength in our dollar benefits importers and international travellers who can get more bang for their buck.

Rising energy prices may also provide further incentives to accelerate the transition to renewable energy and electric vehicles where global demand is surging. However, these transitions to alternative energy sources also take time, and countries with established capacity in these sectors stand to benefit the most.

Markets are reacting to expectations as much as realities, and businesses are making decisions in an environment where conditions are changing rapidly.

Even if geopolitical tensions ease in the near term, the economic effects will persist due to the inherent delays in global supply chains.

For Australia, this means continued exposure to higher costs and potential economic slowdown. For business leaders, the key challenge will be navigating uncertainty while keeping costs down. 

Dr Jamie L. Cross is an Associate Professor of Econometrics & Statistics at the Melbourne Business School, University of Melbourne. He teaches Data Analytics in the Part-Time and Executive MBA programs. To learn more about our academic research and insights, visit the Faculty and Research page.