The rumour mill has gone into overdrive. Conspicuously, there are contrasting interests and views that have and will have profound impacts on oil prices and cause spikes in volatility. After the rejection from the OPEC+ group to increase output consuming nations are turning to the last resorts to put extra barrels to the market – SPR. Bloomberg reported that today the US president would announce the release of strategic barrels in concert with other consuming nations, according to multiple sources who wished to remain anonymous. Reuters reported a similar story by similar sources from Japan and India. The two consuming nations are reportedly threshing out the details of how to use strategic stocks for commercial purposes.
On the other side of the coin is the central banker of the oil world, the OPEC+ group. Delegates (unnamed) reportedly told Bloomberg that the producer group is contemplating to reassess its original schedule to raise output by 400,000 bpd per month. Whether the potential move is a response to the SPR release is not entirely clear. What is, however, obvious is that the gloves are coming off and the battle of influencing the global oil balance and prices is getting heated between consumers and producers. This environment is the recipe of prolonged volatility.
The complex issue of inflation
There are currently three headwinds the oil market is facing, or better say there are three reasons why the rally that took the price of Brent to nearly $87/bbl by the end of October has run out of steam and pushed the European benchmark some 10% below this peak. The first one is the resurgence of the coronavirus infections in Europe. It leads to the re-introduction of lockdown measures hindering healthy economic performances and putting a negative spin on oil demand growth expectations. The second one is the co-ordinated effort of oil consumers to push price lower by using emergency stocks to create artificial supply, as mentioned above. (In a way the loose alliance of the Organization of Petroleum Importing Countries is being born in front of our eyes made up by China, Japan, South Korea, and India. It is, however, intriguing to note that the main instigator, the US, is actually a net exporter that is putting pressure on genuine importers to align their interests with that of the US.) The third one is the fears of protracted inflation, which originates in the recovery from the pandemic.
Our view is that the former two will only have a short-term negative impact on the oil balance and consequently on oil prices. Lockdowns and other restrictions in Europe are likely to be lifted latest by the end of winter and the virus-sensitive part of the economy, the hospitality and the travel sector, amongst others, will be revived. The possible SPR release, if it takes place at all, a.) has probably already been reflected in the prices and b.) will lead to lower oil inventories, which is anything but bearish in case of an emergency, the very reason SPR was created. Consuming nations will not be able to influence global supply effectively other than briefly.
The impact of inflation on the oil balance and oil prices is a tricky one and simply put, there is no consensus amongst analysts, market players and policy makers how to read recent developments on this front. The health crisis has brought with it a literally unprecedented situation and whilst the steps taken by governments and central banks to deal with the devastation were the correct ones under the circumstances the long-term consequences are anything but clear.
Assorted fiscal and monetary stimuli were always expected to help economies recover. Government programmes to encourage spending, central banks’ measures to cut interest rates and create additional supply of money by buying bonds from the open market reached the desired impact. Aggregate demand started to rise and with the economic revival consumer, as well as producer prices began their ascent. What was unforeseen is that this healthy increase in aggregate demand would be coupled with supply chain bottlenecks, which amplified the price rise across every segment of the economy.
The dilemma policy makers are facing is to correctly predict when the inflation in prices will reach its peak. The problem investors are facing, both oil and financial, is how it will impact their markets. After all, the past few months have made it clear that different parts of the world intend to deal with inflation in different manners. Several countries, especially developing ones, have already raised interest rates. Major economic powers, the US, the EU, the UK and Japan are still employing a wait-and-see attitude. The US central bank believes that inflationary pressure will be transitory and once supply chain issues are resolved consumer and producer prices will consolidate. The European Central Bank stands firm on its view that tightening is premature when dealing with supply-induced inflation shock. The Bank of England surprised the market by not raising interest rates at its last policy meeting but signalled an increase in “coming months”. The Bank of Japan forecasts low inflation for years to come and has gone as far as to launch a new $350 billion stimulus in its effort to incentivize consumption.
Conventional economic wisdom states that the most effective way to fight galloping prices is to raise interest rate. Borrowing would be more expensive, aggregate demand, including that of oil, would fall and overheated economy would cool considerably. If those who expect a halt in rising prices soon prove to be correct, then there will be no need to raise interest rates and demand would not be centrally dented.
Judging by the performance of the US bond market investors are positioning themselves for a rate rise but it is not entirely clear when. The 3-year bond yield rose above 0.9% yesterday and the 10-year yield is at 1.6%. (Yesterday’s bond sell-off was admittedly partly triggered by the re-appointment of Jerome Powell, as the head of the Fed.) This is also what the dollar strength suggests although the exchange rate of the greenback is influenced by other factors, too.
As for oil, despite the recent weakness there are no signs of fears of deteriorating oil demand down the line. The structures of the two main crude oil futures contracts are convincingly backwardated for years out. If no interest rate rise is forthcoming from the US, the EU and Japan then oil can actually be used as a hedge against reasonably high consumer and producer prices. Of course, further, and protracted rise in inflation might force these central banks to change their seemingly solid views, in which case these hedges would be unwound. The current picture is blurred at best, yet the oil market presently does not expect major drama that is based on inflationary concerns. May be the consensus is that as soon as the pandemic is irrevocably under control and the tight supply in the labour market eases supply chain bottlenecks will disappear putting a cap on further price rises, hopefully some time next year.