At the beginning of the previous quarter, we expressed an optimistic view on the global economy and on oil prices. The recovery was expected to continue due to the wide-spread roll-out of inoculation programmes and the massive monetary and fiscal stimuli that provided invaluable support to almost every segment of the society and the economy. We also pointed out that the upbeat view will only need to be amended in case of rising inflation that would lead to the withdrawal of financial support or if the OPEC+ group produces more oil than expected either because of the re-emergence of dissent between members or due to Iran coming back to the world’s export market.
As it turns out, inflation was the main talking point and price driver in the third quarter. Inflated prices can be tamed by tightening ultra-loose monetary policy via scaling back on bond buying or ultimately raising interest rates. The two types of inflation are demand-pull and cost-push inflation. It was widely anticipated that, after the global economy started its arduous crawl out of the deep hole dug by the coronavirus, producer and consumer prices would rise because the baseline was unprecedently low. The world literally came to an almost complete standstill at the height of the pandemic last April and May. As mobility restrictions were gradually eased and Covid vaccines became available aggregate demand understandably started grow. What took most by surprise was that the supply side also played its part in the price rise. The shortage of everything -workforce, including seafarers, containers, microchips, raw materials- has raised the voice of those who argue that inflationary pressure will be protracted and not transitory.
This is the dilemma central banks are facing and investors are desperate to find an answer to: how long can policy makers kick the can down the road before lifting monetary support? Are the fears of stagflation, where prices keep rising but growth suffers, vindicated? Some countries have already taken pre-emptive steps. To ease the inflationary pressure Brazil, Hungary, Norway, Pakistan, and Paraguay have all raised interest rates.
The world’s greatest economic powers are slowly warming up to the idea of having to manage their overheating economies. The Fed chair, Jay Powell, finds it “frustrating” that supply chain bottlenecks hinder economic growth and hinted at tapering as early as next month. Expectations of withdrawing monetary help led to a volatile trading in the bond market where yields have risen during the last quarter. The governor of the Bank of Japan also believes that the yawning gap between supply and demand will not narrow in the immediate future. The ECB president is somewhat the odd one out. Christine Lagarde “is not for turning” and she reckons that the current upside price pressure is transitory and as supply normalizes inflation will moderate, too. The stock market performance, bond yields and the dollar exchange rate will be greatly influenced by the action of the central banks. The political tug-of- war in the US about raising the debt ceiling and avoiding default will also be eagerly watched in the last quarter of the year.
As the market prices in declining intervention from central banks equities finished the third quarter of the year lower whilst the dollar strengthened. Oil has weathered these financial headwinds remarkably well in the third quarter. It is down to several reasons. Firstly, oil demand is growing. From 2Q to 3Q it increased 2.84 mbpd (OPEC data) and global thirst will grow by another 1.24 mbpd in the incumbent quarter. Secondly, Hurricane Ida shut in around 40 million bbls of production. This helps to tighten the oil balance for the rest of the year. OECD oil inventories are set to fall below 2.8 billion bbls, down from 2.9 billion bbls in 2Q and 2.812 billion bbls in 3Q.
The most important factor, however, that supports oil prices is the global energy crunch triggered by natural gas and LNG shortages. Front-month NYMEX natural gas gained 60% in 3Q and regional natgas prices are making fresh all-time highs almost on a daily basis. A combination of factors triggered this unprecedented run up in prices. The colder-than-average winter last year depleted global stocks, which could not be replenished due to healthy demand from China and Europe during the summer. Operational problems at several LNG terminal and constrained Russian deliveries have also ostensibly contributed to the supply shortfall. The next shock could come at the end of October. This is when Algeria threatens to shut down a natural gas pipeline that passes through Morocco and delivers the product to Spain and Portugal. Current natural gas and LNG prices imply a crude oil price of well over $100/bbl. In case of yet another freezing winter and continuous shortage the switch from gas to alternative fuel, including Heating Oil, would be inevitable, which would support crack spreads and the whole oil complex.
This is the fundamental backdrop as the finish line of 2021 is fast approaching. The speed, with which oil prices have risen this year has slowed considerably but it would be too early or pre-mature to write off further strength. Oil demand is holding up well and supply might have difficulties to catch up. Of course, in case gas prices come crashing down a layer of support would be pulled from under oil prices and medium-term price peaks could have been found last week under this scenario. The other factor that could reverse the current optimism is a bigger-than-expected rise in OPEC+ output. The current 400,000 bpd monthly increase will not create an oversupplied situation but the pressure from the US on halting the price rally is growing on the organization by the week. This is the clearest signal that the White House does not expect the Iranian nuclear agreement to be revived any time soon. As OPEC+ energy ministers are discussing today how it is best to manage the oil market next month so we will find out soon enough their intention. Given the looser oil balance in the early part of next year it would not be logical to add extra barrels to the market now only to take them off a few months later. It would probably be more reasonable to continue with the agreed policy this year and re-visit the issue at the beginning of 2022. During the last quarter of 2021 oil might keep ignoring the inflation-induced woes in the financial markets.