From feast to famine
15 May 2018
What happened to cheap oil? Brent prices have been rising steadily and are currently trading at $78 a barrel. This represents a 50% increase over the past 12 months and the highest price recorded since oil started to fall precipitously in late 2014. There are a number of explanations for this ramp up, mostly centred on concerns over oil supply. The US withdrawal from the Iran nuclear deal was the trigger for higher prices last week, raising uncertainty around Iranian crude exports. This adds to fears over Venezuelan production and broader geopolitical tensions in the Middle East. Shifts in oil prices, driven by supply shocks, have a number of tell-tale implications. Easiest to spot is the effect on inflation as higher oil prices feed directly and indirectly into consumer prices. Across the OECD, CPI was up 2.6% in six month annualised terms in Q1, led by an 8.2% rise in energy price growth. When exploring trends in household consumption in a recent edition of this publication, we noted that this inflation squeeze likely contributed to weak consumer spending at the start of the year. Of course, not everyone loses from higher prices, with producers/exporters feeling the benefit through stronger production and investment.
Oil supply concerns represent a sudden shift from the environment of abundant production and low prices between 2014 and mid-2016, when OPEC attempted to wrestle market share away from rapidly growing shale producers. With prices rising again, will shale oil be able to fill the supply gap? ECB research based on micro data from shale producers suggests that existing wells can produce up to 6 million barrels per day. Moreover, it estimates that at prevailing prices this could rise to almost 10 million barrels as new projects become profitable. The downside is that it will take until 2020 for these wells to come on line. Therefore, while shale continues to represent a structural change in oil supply dynamics, this is still not elastic enough to prevent short-term tightness. The oil futures forward curve, which we and most central banks condition our forecasts on, shows that the markets expect the recent spike to prove temporary, with Brent to slowly decline from current levels. However, should prices continue to spike, then this oil supply shock risks throwing a spanner in the works of the synchronised global upswing.