Brian Gaynor: Petrol price still too high

The sharp decline in oil and dairy prices could have a huge impact on the domestic economy as the former is our largest import item and the latter our biggest export earner.

Petroleum imports were $8 billion, or 15.8 per cent of New Zealand’s total imports in the October 2014 year while milk powder, butter and cheese accounted for $15.5 billion, or 30.4 per cent of the country’s exports over the same 12-month period.

The benchmark Brent crude oil price has fallen 45 per cent – from US$115.65 a barrel to $63.16 a barrel – since its year high on June 19 while the important whole milk powder price has plunged 55 per cent – from US$5005 a tonne to $2229 a tonne – since February.

Why have these prices fallen so far in such a short period of time and why are consumers not receiving the full benefits of these commodity price drops at the petrol pump or in the supermarket?

The sharp drop in oil prices has mainly been due to the substantial increase in hydraulic fracturing, particularly in the United States.

Fracking is a relatively new commercial development whereby energy explorers go deep into the ground, drill horizontally and blast the shale rock with a mixture of water and chemicals. This releases oil and gas which then rises to the surface.

According to one authoritative study the world’s oil shale resources may be equivalent to more than 5 trillion barrels of oil with more than 1 trillion barrels recoverable using current fracking technology.

By comparison, the world’s proven conventional oil resources are estimated to be around 1.3 trillion barrels.

Fracking is widely accepted in the United States, partly because most land owners have a beneficial interest in mineral resources below the surface. These land owners lease their property to energy companies and receive relatively large rents on prospective property. This gives US landowners a strong incentive to encourage fracking. This incentive doesn’t exist in New Zealand because mineral resources below the ground are beneficially owned by the Crown.

US oil production peaked at 9.6 million barrels a day (b/d) in 1970 and then declined to a low of 5 million b/d in 2008 as conventional oil reserves were depleted. It has picked up sharply in recent years because of fracking and is now running at a daily rate of nearly 9 million barrels.

US production is forecast to increase to around 9.5 million b/d over the next 12 to 24 months. This forecast was made before the recent sharp drop in prices which will probably lead to some production cuts.

The main reason for the recent price decline is that world supply, mainly because of the United States, is growing more rapidly than demand. Opec (Organisation of the Petroleum Exporting Countries) produces 30.3 million b/d and the rest of the world 61.8 million b/d.

The two largest non-Opec producers are the United States and Russia, with the latter reporting daily production of 13.4 million barrels.

Opec is unwilling to cut production for a number of reasons including:

• Most member countries are heavily dependent on oil export revenue.
• They have to meet interest costs on large government deficits.
• They believe that lower oil prices in the short term will discourage further investment in fracking and ultimately lead to higher long-term prices for conventional oil.

The United States Energy Information Administration’s latest Short-Term Energy Outlook, which was released this week, forecast an average Brent price of US$68 a barrel in 2015.

Meanwhile 91 octane pump prices have fallen just 10.4 per cent in Auckland, from 220.9 cents a litre to 197.9 cents a litre, since June 19. The Brent crude oil price has declined by 45.4 per cent over the same period.

After adjusting for the changes in the NZ dollar/US dollar exchange rate the price of Brent crude oil, in NZ dollar terms, has fallen by 38 per cent over the same period.

However, the issue is further complicated by the country’s petrol tax regime which has the following excise duties:

• 56.524c a litre for the National Land Transport Fund.
• 9.90c ACC Motor Vehicle Account.
• 0.66c Local Authorities Fuel Tax.
• 0.045c Petroleum or Engine Fuels Monitoring Levy.

Thus, we have total petrol excise duties of 67.129c a litre before tax.

In addition, GST is collected on the overall price of fuel, including excise taxes.

Thus, GST on excise tax is a ‘tax on taxes’.

If we take into account current world oil prices, the NZ dollar/US dollar exchange rate and petrol taxes there is a strong argument that 91 octane should be selling for around 170/175c a litre instead of 197.9c a litre at present.

However, the major oil companies may be unwilling to pass on most of the benefits of low oil prices because they are also oil producers. These production operations are being adversely impacted by the sharp drop in international oil prices.

Nevertheless, motorists should benefit from relatively modest decreases in pump prices over the Christmas/New Year period.

Dairy commodity prices have been in freefall for most of 2014. Individual products have experienced the following declines from their March 2014 quarter highs:

• Butter prices have fallen 40 per cent.
• Cheddar is off 41.2 per cent.
• Skim milk powder has declined 49.3 per cent.
• Whole milk powder prices have plunged 55.5 per cent.
• The Global Dairy Trade (GDT) Index has fallen 50.1 per cent.

The problem with the dairy sector is that there has been a large increase in worldwide production as farmers have responded to the higher prices in previous years as well as favourable weather conditions in most producing countries.

In addition, Chinese importers have cut back on their buying as they digest product purchased earlier this year.

Most agriculture economists believe that dairy prices will remain relatively low until mid 2015 at least and any recovery after that will be slow.

The perplexing issue for consumers is that dairy commodity prices have halved since February yet domestic fresh milk prices have risen 5 per cent over the same period according to Statistics NZ’s Food Price Index.

Fonterra will argue that there is little relationship between international commodity prices and domestic fresh milk prices. For example, dairy commodity prices surged 175 per cent between February 2009 and February 2014 yet domestic fresh milk prices increased by only 11 per cent over the same period according to Statistics NZ.

Nevertheless, there is no doubt that New Zealand farmers are delighted that the increase in domestic fresh milk prices offers some protection against the sharp drop in international commodity prices.

Dairy farmers face a fairly bleak 2015 as this week’s revised payout forecast of $4.70 per kgMS indicates that Fonterra farmer shareholders could experience an income decline of up to $6 billion in 2015 compared with 2014.

The dairying downturn is the one dark cloud hanging over the New Zealand economy next year because the decline in imported oil prices and higher returns for beef and sheep farmers are unlikely to compensate for a subdued dairy outlook.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.