Why Are Oil Prices Rising And What Does It Mean For Inflation?

Last week, the price for West Texas Intermediate crude oil rose to a new one-year high.

At one point, WTI crude was trading about US$94 a barrel.

Brent crude, another widely followed benchmark, also peaked last week, reaching its highest level since November 2022.

Prices have since corrected somewhat, but oil is still up about 30% since March.

How come?

Shouldn’t rising interest rates have dampened demand for oil?

And does the rise in oil prices present a challenge to central banks?

Worries about renewed inflationary pressures stoked by rising oil prices are spreading.

Last month, the Wall Street Journal ran this headline, ‘The Fed’s Next Challenge: $100 Oil’.

Some market participants think high oil prices will push inflation higher.

David Fyfe, chief economist at Argus Media, said rising oil prices ‘clearly risk pushing … inflation slightly higher again. It is something that may encourage, through the end of the year, further interest rate hikes’.

Uh-oh.

Not more interest rate hikes.

Our own Reserve Bank Board is meeting later today. Let’s see if it put any emphasis on rising oil prices in its decision.

The Board’s September meeting minutes only mentioned oil prices once, perfunctorily noting prices rose 20% from their June trough.

But like I said, oil’s steady march higher in 2023 raises some interesting questions.

Chief among them is — why?

Oil price and the economy

Oil lends itself well to basic economic analysis.

So let’s conduct one now, using some hand-drawn charts on my part.

It’s often said oil is a barometer of economic health with oil prices transmitting the vitality of economic activity.

Popular thinking posits that a waning oil price represents a listless economy; a rising price represents a vigorous one.

At least, that’s the sketch of things on the demand side.

But even a supply shock would send oil prices higher only if overall aggregate demand holds firm.

I can quickly illustrate this with a rudimentary , hastily scribbled.

Like so:

When the aggregate demand for oil is steady, a supply shock shifts the aggregate supply curve leftward, raising the equilibrium price.

The claim that rising oil prices imply a healthy economy can be expanded into a basic syllogism.

And this basic syllogism can lead to some interesting entailments.

For instance, plenty of data has shown that economic growth in advanced economies has slowed as cost-of-living pressures rise.

Australia itself is technically in a GDP per capita recession.

So, we can turn the syllogism into this:

1. If oil prices are rising, then the economy is healthy.
2. The economy is not healthy.
3. Therefore, modus tollens, oil prices are not rising.

But they are.

What gives?

Either the economy is in better shape than we realise, or oil prices can rise even when the economy is not in good nick.

How is the latter possible?

Let’s assume an ailing economy leads to a downward shift in aggregate demand for oil.

In that case, oil prices can rise only if aggregate oil supply suffers a HUGE supply shock disproportionate to the fall in demand.

That would look something like this:

A shock causes the supply curve to shift from Supply1 to Supply2, overpowering the fall in aggregate demand.

But has the world really seen a huge supply shock in recent months?

Despite OPEC’s production cuts, supply is still not catastrophically impacted.

In fact, the International Energy Agency said in its latest oil market report that world oil supply in 2023 will rise by 1.5 million barrels a day.

While OPEC+ is curbing production, ‘record US and Brazilian supply underpin a 1.9 million barrels per day increase in non-OPEC+ production from January to August.’

Yet despite the production bump from non-OPEC+ countries, oil inventories are dwindling.

Global oil inventories fell to a 14-month low in August.

What does that suggest?

Demand is still strong.

The world is still hungry for oil.

The IEA said world oil demand is set to grow by 2.2 mb/d in 2023 to 101.8 mb/d.

So, oil demand and oil supply are set to rise in 2023.

And as economists Robert Hall and Marc Lieberman wrote in their microeconomics textbook:

‘Regardless of what happens to supply, demand must increase in order for both price and quantity to rise.’

What accounts for the rise in demand?

A ‘least-interesting but most logical answer’:

‘The answer would not make a good premise for a Hollywood thriller. It is far less interesting than crazed speculators or villainous manipulators. The demand for oil … increased because — quite simply — firms wanted to use more oil at any given price.’

So what does that suggest about the state of the global economy?

It is still resilient.

That corroborates the ‘higher for longer’ camp.

Just look at the bellwether economy — the United States.

The US economy is still going strong, especially when you measure that by the output gap.

The output gap measures the discrepancy between an economy’s actual economic output against its potential.

The output gap tends to widen and become negative when the economy contracts. The gap shrinks or even becomes positive when the economy is surging.

Well, the US output gap is currently narrowing, suggesting the US economy is still sound.

Does this look like the US is approaching hard times?

At the very least, we can only say ‘not yet’.

But monetary policy acts with a lag.

And we are yet to feel the full brunt of the rapid interest rate hikes.

Regards,

Kiryll Prakapenka,
Editor, Money Morning