WHAT ARE THE IMPLICATIONS OF THE CORRECTION IN THE OIL MARKET?

18.07.2022 Over the last month oil prices have fallen by around 20 percent. Below we look at the outlook for the oil market and its wider implications.

After falling to USD 20 a barrel during the pandemic oil recovered to around USD 60 a barrel on the re-opening. Following the Russian invasion of Ukraine, it traded above USD 100 a barrel. Oil prices have been high in recent months for two reasons. Firstly, there is very little spare capacity in the oil market. This is because investors are more and more reluctant to fund new projects in what is increasingly viewed as a legacy product. Secondly, Western sanctions on Russian oil exports are expected to gradually reduce Russian production. This is viewed as a meaningful supply shock as Russia is the world’s second largest crude oil exporter behind Saudi Arabia.

In the Spring of this year analysts were talking about oil prices of USD 150 a barrel. However, faster than expected interest rate rises from the US central bank have seen economic growth and oil demand estimates lowered. Furthermore, it appears that in developed economies higher oil prices prompted reduced consumption, also known as ‘demand destruction’.

Due to low levels of spare capacity oil prices are likely to be volatile. Certainly, any supply outages, due for example to the hurricane season prompting temporary oil rig shutdowns in the Gulf of Mexico, will have a meaningful short-term influence on the price. However, evidence of demand destruction at over USD 100 a barrel suggests that demand can adjust relatively quickly to changes in supply. Furthermore, it should be noted that there are powerful political interests, namely the US government, that have a strong desire to keep a lid on oil prices.

A stabilisation of oil prices at around USD 100 a barrel will have a significant effect on inflation in developed economies. For example, in the United States it could knock around 3 percentage points off the annual inflation rate (currently 9.1%) over the next year. Indeed, if current oil prices are maintained it should mark the peak in the US annual inflation rate.  In Europe falling oil prices will also exert downward pressure on inflation. However, this will be partially offset by a looming natural gas shortage next winter as Russian exports into Europe are expected to fall sharply. The implications for the equity markets of a stabilisation in the oil price will be discussed in the next post.

For information only. Investors should seek professional advice for their own circumstances before making an investment.

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This post was written by Robin