It’s becoming increasingly clear that the conflict could last all year – with negative consequences.
Trump’s demand for “unconditional surrender” leaves no room for the face-saving exits required to cut a conflict short. Iran's government has vowed to keep the Strait of Hormuz closed.
Oil is a global market, sure enough. But Asian (including Australian) consumers will likely be most affected as they (we) take the majority of the crude and products that transit the strait.
Meanwhile, gas is not a global market. European (TTF), East Asian (JKM), and US (Henry Hub) gas prices vary wildly. The loss of Qatari supply - which, alongside Australian LNG exports, mostly feeds the Asian market - spells trouble for the region.
Physical vs paper markets – a clear divide
Physical markets have been alive to the size of the problem from the beginning. Crack spreads, which reflect the cost of turning crude oil into useful products like jet fuel (kerosene), heating oil, and petrol, have exploded. This is an unmistakable signal that the price of food, plastics, and many other inflation components will rise. Australian Treasurer Jim Chalmers predicts inflation could hit 5%. Should oil hit $150 a barrel, as Capital Economics is forecasting if the war extends several months, Chalmers forecast will almost certainly prove conservative.
Prices for physical oil cargoes have lifted off too. This signals that consumers will pay a big premium to get their hands on barrels, and that importers don’t expect the war to end quickly. Some Asian countries like the Philippines, Bangladesh, and Sri Lanka have already introduced government initiatives to reduce oil consumption.
Oil paper markets - e.g. futures - have reacted less, but even here things are starting to change. Over the past two weeks, the oil futures curve has moved higher and flatter, with most of the 2027 Brent strip now trading above $75.
ASX energy stocks haven't priced in a long war
Oil has surged roughly 40-50% since hostilities began. But the rally for ASX energy companies has been surprisingly tame. Most are barely trading above their five-year price averages.
Why is this? I suspect ESG mandates are a big part of the reason. Institutional investors like super funds are the price setters on the ASX. Many of them refuse to touch fossil fuel stocks, whatever the dividends on offer.
Self-directed retail investors are becoming steadily more influential in ASX price formation, according to the 2023 Australian Investor Study. Since younger generations of retail investors often avoid fossil fuel companies, large pools of Australian capital effectively boycott the sector, creating a permanent discount.
Be this as it may, the bigger reason ASX energy stocks have hardly moved in five years is that the cash equity market, like the oil paper market, expects some kind of near-term mean reversion. Broker models from the bulge bracket banks still embed a return to $70 oil.
ASX energy stocks may offer a hedge to declining living standards
An extended US-Iran war will likely be inflationary, threatening a decline in living standards. So what then is to be done?
The first thing is to prepare for a higher interest rate environment in Australia. The RBA was split 4–5 on its decision to raise rates on Tuesday. This has blunted confidence that more rate hikes are coming; interest rate futures have lowered the probability of another rate hike from 65% to roughly 20%.
Higher interest rates matter for inflation because they help keep the Aussie dollar strong. As oil is priced internationally in US dollars, a higher AUD makes oil and its derivatives cheaper for us.
The second thing is to prepare for a difficult time for the ASX 200, outside of the energy segment. In a high-oil-price-driven stagflationary environment, the only pocket of the ASX likely to succeed is the narrow band of upstream producers: Woodside, Santos, Beach, and Karoon.
Here, the previously Melbourne-based Karoon has the strongest sensitivity to the oil price of any ASX energy stock. This is reflected in the graph at the bottom.
Lastly, an extended war will re-politicise the east coast gas framework. Despite recent reforms, the architecture still favours exports. If JKM prices continue to surge, we face a wealth transfer from Australian households to energy shareholders, and a scenario the Albanese government will find difficult to ignore.
