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Rising oil prices and inflation

Analysts at JP Morgan have said that with Opec+ ‘firmly in the driver’s seat’ oil futures could test $125/barrel in 2022.

There is no need to highlight the fact that the price of energy commodities has soared in the last few months as we can all most likely feel it in our wallets. Oil, as a source of energy, arguably has the largest effect on economies through its effect on the price of fuel, which just seems to keep rising.

The sharp rise in fuel prices is a result of a tightening oil market. Brent crude oil has risen substantially year to date and hit a high above $80/barrel for the first time in over three years. While it has since pulled back, it is still up just over 40% year to date. The rising oil prices can be felt across the economy, affecting both economic growth and inflation.

The figure above indicates that the oil price took a massive hit when the Covid-19 outbreak ensued in March 2020. The spread of the virus caused governments around the world to impose lockdowns and close borders which in turn caused a crash in the demand for oil. This was further exacerbated as Russia and Saudi Arabia simultaneously entered a price war, consequently resulting in a fall of Brent crude to a low of around $19 per barrel.

The question is why is there the sudden uptick in oil prices and what does the future hold?

The predominant reason for the current rise is attributed to simple supply and demand dynamics. As global economies began reopening after lockdowns – meaning increased travel, manufacturing, etc. – we saw a gush of pent-up demand rush in. Global demand for most refined products (barring jet fuel) is pretty much back at pre-pandemic levels thanks to vaccination rollouts in many of the largest oil-consuming countries.

On the supply side, Opec+ (Organisation of the Petroleum Exporting Countries Plus) originally cut the supply of oil at the onset of the heavy lockdowns in 2020 to support the oil price which was dragged down by depressed demand. They have since been hesitant to increase supply in an effort to restore inventory levels to normal. Inventories during the period of lockdowns skyrocketed and thus it makes sense that Opec has been holding back supply in order to stabilise inventory levels. Inventory levels are now close to pre-pandemic levels but Opec+ are still hesitant about adding more supply despite major countries urging them to do so.

The reason is that demand may be strong at the moment, but we are still in very uncertain times. A great example is how the spread of the delta variant and the subsequent lockdowns were able to curb demand for oil and subsequently depress prices. Now, the new omicron variant has been discovered and could potentially have the same or even worse effect on demand. Thus Opec+ is very hesitant to increase supply in case demand drops off due to these uncertainties.

It is quite easy to see how the current dynamics have caused a squeeze in the oil market with the potential for the price to rise even further. The price of oil is currently easing off highs due to the new omicron variant raising questions about future demand. However, demand will not be subdued indefinitely should the variant spread and once we gain some sort of control over it then this coupled with supply that is being kept low by Opec+ could propel prices even higher.

Morgan Stanley noted that the new variant would suppress prices in the short term and subsequently decreased their forecast for the first quarter of 2022 to $82.50/barrel from $95/barrel previously. They have however stated that oil prices could reach new highs after mid-2022 and raised its Q3 2022 forecast to $90/barrel from $85/barrel. On the other hand, analysts at JP Morgan have said that with Opec+ “firmly in the driver’s seat” oil futures could test $125/barrel in 2022 and even $150/barrel in 2023.

If oil prices do continue to rise, then the question is what impact will it have?

The short, simple answer to this question is inflation. History has taught us that the price of oil is positively correlated with inflation, i.e. they tend to rise and fall together. The link between the two comes from the fact that oil is a major input in any economy as it is used for vital activities such as transportation. When the everyday consumer thinks about rising oil prices, we think about the price of petrol going up, however, it also has much broader consequences.

Oil prices affect an economy in several ways. They directly affect the price of goods made with petroleum products and indirectly affects costs such as transportation, manufacturing, and heating. Once these indirect costs trickle down the supply chain then the price of end products is bound to rise. This rise in costs will in turn hurt consumer spending and dampen economic activity.

Having a line of sight of the broad-based consequences that the rise in oil prices could have on the economy paints a rather dim picture for the future. However, it is one that cannot be ignored. For now, we can just keep our eyes open and be prepared for all scenarios.

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Mauro Forlin

Global & Local Asset Management

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