Storm Warning

Hurricane Katrina is a reminder to all investors that their fondest assumptions can be blown away if the wind is strong enough. Katrina certainly looks strong enough, and it's blowing in the right, er, wrong place. With it comes good and bad news.

A hurricane at one place at one time should hardly matter so much to investors, particularly Australian investors who are far from the storm. But with the oil price already rising rapidly, Katrina threatens to strip bare the precarious structure of the oil industry. In the US, oil production capacity is already stretched to the limit, so any interruption to US supply has ramifications for all investors, wherever they are.

Katrina is the second category 5 hurricane in 100 years, with consistent eye-wall wind velocities of more that 250 kilometres an hour, and gusts to 320km/h. It's been travelling towards New Orleans (less than 200 kilometres from the eye this afternoon AEST, and 160 kilometres up the Mississippi from the Gulf Coast) at an average speed of 19km/h. Landfall is expected before midnight AEST).

Ships have already moved out to sea, and the Louisiana Offshore Oil Port (LOOP) has been closed. The LOOP, which takes 1 million barrels a day of imported crude (11 per cent of total daily oil imports into the US), is America's biggest oil-import terminal. It is 35 kilometres offshore and right in the path of Katrina.

The US Gulf Coast accounts for at least 25 per cent of US oil production and refining. So far, 42 per cent of Gulf oil production, 20 per cent of gas production and 10 per cent of the nation's refining capacity has been shut down.

Potentially, the amount of Gulf crude oil production that Katrina could render idle is equal to almost the whole of global spare capacity. This potential supply tightness has been reflected in the past 24 hours in NYMEX and Singapore futures prices of crude and product, peaking at more than $US70 a barrel for October delivery. Supplies of diesel, aviation fuel, unleaded gasoline, natural gas and propane and heating oil are all at risk

The total evacuation of New Orleans (population around 1.3 million) has been ordered. Estimates are that a direct hit on the Gulf coastal infrastructure by this hurricane could have an insurance cost of between $US30 billion and $50 billion.

There is now a hydrocarbon-price spike (crude, products, natural gas) of unknown duration, created by the addition of a short-term supply-side shock to an underlying long-term demand shock for energy that has been created largely by the industrialisation of China.

In effect, it is a double-whammy for the price of energy. At some point, the second whammy (the hurricane) will blow itself out and prices will subside '” but probably not to their previous levels.

The key point to remember is that, underlying demand strength is being driven by the rapid economic transformation of several enormous newly industrialising countries, notably in Asia, and this is itself superimposed on stronger cyclical growth in the industrialised world.

America's economy is accelerating again, Europe may have hit bottom and Japan is no longer in recession. Even without the present help of Katrina, the world economic cycle is now reinforcing the energy-demand trend and forcing up prices.

You can be quite confident that energy prices will be very well supported for a long time to come because of the power of the underlying demand trend.

The good news for investors is that energy-exporting economies (Australia, Canada, Mexico, Norway etc) are facing very favourable terms of trade and appreciating currencies. Their strengthening currencies will also tend to dilute the effects of rising global inflation in such energy-rich economies, because their landed imports will be cheaper. Their asset prices should perform better than those of their economic rivals.

Energy-deficient economies, by contrast, will face rising inflation and falling terms of trade, resulting in upward pressure on local interest rates and weaker financial asset prices.

But it must be remembered that the continued economic transformation of the newly industrialising countries (NICs) is in turn driven chiefly by open trade with the First World. So the strong overall global demand for energy will be wholly contingent on the maintenance of the ''globalisation'' program linking the NICs' producers of manufactures with the First World's consumers. If free trade stumbles, so too then will energy demand (and prices). And so will the prices of non-energy raw materials. In short, any serious long-term disturbance to the new bullish global equilibrium could be very bad for everybody's growth/inflation profile.

We have all been agonising about "conventional" threats '” war in Asia, global terrorism, US congressional trade-protectionism, policy mistakes by the US Fed, hedge fund collapses . . . but we've forgotten about the effects of a highly-focused natural disaster (earthquake in Tokyo, collapse of Three Gorges Dam in China, nuclear reactor accident in Taiwan etc). Hurricane Katrina could well be such a focused natural disaster.

INVESTMENT IMPLICATIONS

The oil and hydrocarbon-product markets are already as tight as a drum. A serious supply shock, such as a direct-hit by a huge hurricane on the US Gulf Coast, will have a drastic effect on prices. There is no way of knowing how long that price spike might last '” it will depend on the amount of physical damage sustained by production platforms, pipelines, refineries, tank farms etc. It certainly seems, at this stage, that Hurricane Katrina's intensity has the potential to inflict severe and long-lasting damage.

Nevertheless, hurricanes can change direction and peter out. That would provoke a quick relapse in the present oil-price spike, though maybe not to pre-Katrina levels.

Even if Katrina does not cause substantial damage, there is evidence that global warming has raised both the frequency and intensity of Atlantic and Mexican-Gulf storms. So far in 2005, June was "unusually active", July saw five big storms including two hurricanes, and August has had five storms and two hurricanes. This equals the storm record established in 1916. There are still three months to go before the end of the "official" hurricane season.

America's oil production, importing, refining and transportation industry is heavily concentrated on the hurricane-prone Gulf coast. The rising threat of such seasonal supply shocks is likely to have an effect on oil-market sentiment.

Because oil-price spikes are inflationary if not quickly and fully reversed, there is a growing chance of inflation becoming embedded in the US (and, therefore, global) economic system. This must generate a rising tendency in interest rates, especially in economies that are dependent on energy imports.

The US economy as a whole is grossly indebted. Its bond market, sharemarket and property market are all vulnerable to any upward movement in inflation and interest rates. A sell-off in long bonds would undermine many share valuations and would also put pressure on mortgage rates. This shakeout in asset prices would in turn undermine consumer confidence (already hurt by the rising cost of gasoline, and the impending costs of heating oil as autumn draws on).

A stalling of US consumer activity and a resulting economic slowdown in the world's biggest and most resilient economy will almost certainly affect world trade flows, and have a potentially serious effect on Asian growth. This would in turn affect world commodity prices and the prospects of major commodity exporters such as Australia if those effects were prolonged.