The Outlook: April 2018 economic
commentary

Commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges

 

Should we worry about the rising oil price?

Amid concerns over a possible trade war, a pull-back in the tech sector and tighter US monetary policy, there are not many assets that have hit multi-year highs in recent weeks. The notable exception has been oil. On 13 April, Brent Crude, the international oil benchmark, rose above (US) $72 per barrel, reaching its highest level since late 2014. With sharp rises in oil prices having preceded recessions in the past, investors are wondering whether there is now another issue to add to their worry list.

The immediate cause of the recent price spike has been geopolitical in nature. US-led missile attacks on Syria following a suspected chemical weapon attack by the Assad regime have heightened concerns over deteriorating relations between the US and Russia. However, over a longer time frame, economic fundamentals have been the main driver of the near-50% gain in the oil price since the summer of 2017. As the global synchronised recovery gathered pace through last year, demand for oil picked up. In addition, an agreement by the Organization of the Petroleum Exporting Countries (OPEC) and its non-OPEC allies to restrict supply and boost prices has seen high levels of compliance.

A hawkish shift in US foreign policy threatens to push the oil price higher in the coming months. The new US national security adviser, John Bolton, is a vocal critic of the 2015 Iran nuclear deal, under which the country was able to resume selling oil in international markets in return for restrictions on the country’s nuclear programme. Should the deal - which President Trump must recertify by 12May - fall apart, a reduction in Iranian supply could tighten the market. There is also a risk that recent US sanctions on Russia could be expanded to target the country’s current oil exports rather than impacting investment in future plants as is currently the case.

Shale as a stabiliser?

A key issue going forward is how US shale producers will respond to rising prices. The rise of shale oil, with its potential to respond nimbly to changes in demand, has been heralded as a stabilising influence on prices. However, recent developments have called into question the capacity of higher shale output to cap the oil price. US crude oil production rose steadily in 2017 to a record high of 10 million barrels per day in November but has since plateaued. There have been reports of supply bottlenecks in the oil services sector curtailing production. And shale producers, under pressure from their creditors, are being forced to focus on profits rather than expanding output. This said production costs have fallen in recent years and new shale wells profitable with the oil price above (US) $50 per barrel on average, an increase in output is expected. The US Energy Information Administration (EIA) projects that US crude oil production will average 10.7 million barrels per day in 2018.

The expansion of US oil production in recent years has been one factor affecting how the global economy responds to changes in oil prices. The conventional wisdom had been that lower oil prices stimulate global growth as cheaper fuel boosts consumers’ discretionary spending, and outweighs the hit faced by Middle Eastern oil exporters who tended to save a substantial part of their income. 

However, the fall in the oil price during 2014-16 did not provide the boost that many observers had expected. In the US, this was because the benefit to consumers was offset by falling investment in the energy sector. The International Monetary Fund (IMF) has also noted that when interest rates are close to zero, a fall in the oil price can, by dragging down headline inflation, increase real (i.e. inflation-adjusted) interest rates, potentially compressing demand. Conversely, a firmer oil price should support investment in the sector and, depending on how policymakers react, potentially depress real interest rates.

Policy response

How central banks respond will depend on the extent and duration of the oil price increase, and whether it is seen as ushering in “second-round” effects. Higher oil prices are already pushing up headline inflation rates, but central bankers are generally more interested in trends in core inflation, which excludes volatile food and energy costs. Reduced bargaining power on the part of workers due to de-unionisation, globalisation and automation suggests that the risk of an oil-induced wage-price spiral is low.

In the US, where inflation is already above 2%, the labour market is tight and the economy is being boosted by lower taxes, higher oil prices might, at the margin, embolden policymakers to step up the pace of rate hikes if they prompt a rise in inflation expectations. However, in Japan and the eurozone, where core inflation remains stubbornly low and recent economic data has disappointed expectations, central banks might worry more about the impact on discretionary household spending.

The rise in the oil price has brought some tangible benefits for financial markets. Higher earnings in the energy sector are expected to be a key driver of profits growth this year. Firmer oil prices have also kept a lid on borrowing costs in the high-yield bond market. This contrasts with the experience of 2014-16 when low oil prices raised doubts about the creditworthiness of highly-leveraged shale operators, heightening concerns for the broader financial system.

Finding “Goldilocks”

The key takeaway is that the relationship between the oil price, the global economy and financial markets is a complex one. Elevated oil prices might be a good or a bad thing depending on whether they are indicative of strong demand or a negative supply shock. Narratives change over time. Recent events have tested the idea, prevalent not so long ago, that the oil price would stabilise around (US) $50-60 per barrel – a so-called ‘Goldilocks’ price that kept producers happy but did not unduly squeeze consumers. There is now talk that Saudi Arabia wants to lift prices to (US) $80 per barrel to fund increased government spending and provide a favourable backdrop ahead of Saudi Aramco’s IPO, now expected in 2019. There is a good chance that the “Goldilocks” range is wider than observers previously surmised. Whereas the experience of 2014-16 revealed the lower boundary of that range, rising geopolitical risks suggest it might now be tested on the upside.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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