Historically, crude oil prices have tended to fuel inflation. This became evident when in 1973 the oil producer cartel OPEC embargoed the West in support of Palestine, and when Iran deposed of the Shah in 1979. In both cases the oil price more than doubled in a short period of time.

It rose, inflation adjusted, from approximately $25 in 1971 to more than $154 in 1980 (WTI). The ensuing supply shortages caused the most severe rise in inflation since the Great Depression. Other than the current inflation shock, which has been brought under control swiftly and seemingly painlessly, it took years and an engineered recession to get galloping prices under control in the 1980s.

The relationship between oil prices and inflation is not linear. The price of crude is volatile, and the path of inflation does not follow it up or down at every turn. Oil more than doubled its price in the wake of the first Gulf War without causing much inflationary harm, while Russia’s invasion of Ukraine in 2022 has caused a local cost inflation for gas that will disadvantage Europe’s industry for years to come.

When demand collapsed during the pandemic, crude oil became unsellable for a short while. The price paid for WTI crude in the US became negative in April 2020. The total collapse of crude oil prices did not produce a disinflationary shock either.

One of the reasons why supply shortages of crude and higher prices are less painful now than in the 1980s is, of course, that we have substituted crude in our energy needs through higher efficiency and the growing supply of renewable energy. The extreme volatility of crude oil prices mask the fact that over time, oil is steadily rising markedly above inflation without accelerating it.

The average price of crude (WTI, inflation-adjusted) is $67 since 1980, but $76.30 since 2000. This may be caused by ever higher production costs. It is certainly more expensive to operate platforms in the Gulf of Mexico, than digging with a spade for a gusher. (In Europe, other than the US, the price of petrol is more shaped by taxes than markets.)

Consumers and central bankers look at energy prices with different glasses. Monetary authorities rightly believe that there’s little they can do about fuel inflation. Crude and distillates are priced by international markets. The tools central bankers wield, raising or lowering the cost of credit and the supply of liquidity by various means, aim at throttling demand. Their manipulations have little or no influence on supply shortages of crude in international markets. This is why central bankers will exclude highly volatile goods like food and energy when monitoring inflation.

For consumers, this seems like undue data manipulation. How much we pay for groceries and how much it costs to fill up the tank of our car is for us the obvious yardstick to measure the pain. We are now mollified that after a 20% surge in prices things seem to have calmed down. After all, prices at the petrol pump seem stable. But not all central bankers are content. The “core” items they follow, like rents, healthcare or restaurant bills, have come down less convincingly than food and gasoline. While we may feel the worst is over, they still worry about “stickiness”.

Oil producers see things from the opposite side. That the oil price is now below the average of the last 25 years is painful for most of them. At $73 at the time of writing, it is too low for comfort. The US, today the world’s biggest producer of crude, has a marked cost disadvantage. To squeeze out oil by fracking and to drill for it in the Gulf of Mexico costs approximately $44 per barrel – four times more than Saudi Arabia and three times more than Russia, the two biggest exporters. Marginal US producers will feel the pain and many will throttle further expansion. Saudi Arabia has budgetary needs and ambitious investment plans necessitating an oil price of $80. Other Gulf producers are similarly dependent on a higher oil price.

If Jeff Currie is right, lower interest rates from now on will revert these money flows back into oil. Coupled with low inventories, this may force the oil price up rapidly- Andreas Weitzer

For oil “bulls”, betting on higher oil prices, the lull is a conundrum. Stockpiles of crude are contracting month to month and are globally precariously low. Exports from Libya have slumped as the standoff between the recognised government in Tripoli and the opposition forces in the east has intensified. Production in the Gulf of Mexico was shut down as Hurricane Francine swept through. OPEC has extended its production cuts to December. The civil war in oil-producing Sudan has caused famine and devastation and decimated exports. The tensions in the Middle East which threaten to engulf Iran, a major OPEC producer, have done little to worry markets.

There’s clearly a persisting mismatch between demand and unmitigated supply. This is good news for the consumer, good news for Kamala Harris. Consumers will be relieved to see petrol prices coming down, feeling less aggrieved. Donald Trump’s ranting about how to further lower the oil price will have little currency with the oil industry.

Most market watchers blame China for the weakening of crude oil prices, pointing fingers at its “stuttering” economy. While the real estate crisis is still weighing heavily on the country, consumers are retrenching and manufacturing capacity is idling, GDP growth of close to 5% is still higher than in most industrialised countries and hardly to blame.

It is possible that China’s rapid advances in renewable energy production is already curbing its need for fossil imports. It is also possible that imports from Russia and Iran are still priced at large discounts, and hence influencing market prices. Whatever the reason, the story of tepid Chinese demand is influencing sentiment.

Last month, Jeff Currie, commodity analyst at Carlyle, the private equity behemoth, came up with a quite different theory. Lured by high interest rates, hedge funds and physical oil traders have diverted investments from oil to money markets, according to Currie. High interest rate income in risk free money market funds would have diverted up to $100 billion, he reckons. “Oil investments would need to yield roughly 15% to compete against the 5% offered by money market funds,” he estimates. Higher finance costs since 2022 have not only prevented traders from investing in future contracts, but also from now more expensive storage of physical crude. Reduced activity in the futures markets have also lowered futures prices (backwardation), making physical arbitrage unprofitable.

Selling existing stockpiles was the more profitable proposition, which may explain historically low inventories.

If Currie is right, lower interest rates from now on will revert these money flows back into oil. Coupled with low inventories, this may force the oil price up rapidly. Retail investors invested in oil stock and oil producing countries like Russia will rejoice. I hope for this to happen late enough to not give a lucky boost to Trump.

Andreas Weitzer is an independent journalist based in Malta.

 

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