Less Oil on US Inflation Fire

April 19 2017

“But what about inflation? Inflation is quite high: should the Fed not keep its eye on the inflation rate and continue its rate hike trajectory? At a first glance, they should. But it would not surprise me if, in the coming months, the need for further rate hikes due to higher inflation is about to ease.” This was the conclusion to my article of last week. This week, I present you with the promised sequel.

The in the course of the last few months rapidly risen inflation could drastically reduce the need for further rate hikes in the coming months. An important driver of higher inflation in the past few months was a rise in oil prices. Oil prices went from $45 dollar a barrel at the end of November last year, to $55 dollar a barrel in recent months. Lately, the price of that black gold has declined a bit, and it would not surprise me if that decline continues into the coming months; a new rise in oil prices seems unlikely. Why is that the case?

On a side note: the fact that oil prices could continue to fall, does not mean that the inflation rate will drop (significantly), but it does mean that a new rise is rather unlikely.

When the oil-producing countries united in OPEC decided at the end of November last year to lower their production for the first time in eight years and even a few non-OPEC members joined the agreement to push oil prices up and raise their own revenues, their strategy seemed to work. The oil price, which stood at around $45 dollar a barrel in November, went up to about $55 dollar a barrel.

Oil Stocks at a Historical High

That rise in oil prices did not mean, however, that oil prices would simply keep rising or even that the new level of $55 dollar a barrel was about to persist. The OPEC, for instance, has an unbelievable bad track record with regard to complying to agreed production quotas. In almost all cases, the OPEC countries continued to produce more than their quotas allow for.

In addition, oil stocks in the US have increased considerably. With a total of 533 million barrels of oil in US oil stocks, that stock is now at its highest level ever. This is important for oil prices, because oil traders know that if and when oil prices rise, the US can use its strategic oil reserves and, with more supply entering the market, push down oil prices.

Another reason why a rise in oil prices was certainly not guaranteed, was the fact that OPEC countries are not the only oil producers that bring oil to the market. Nowadays, almost more than half of total oil production comes from non-OPEC countries. That increase in non-OPEC oil production is mostly due to the US, with its increasing shale oil production.

These factors have indeed brought an end to the recent price increase of that black gold, after an initial increase from $45 to $55 dollar a barrel. In the first quarter of this year, oil prices fluctuated between $53 and $56 dollar a barrel. In the US, for instance, the number of oil producers has doubled in less than a year time because of the rise in oil prices in December. The number of shale oil producers has increased in every single week of this year, except for one, according to data from Baker Hughes.

Recently, the oil price dropped to $50 dollar a barrel. The price rose somewhat after geopolitical worries, especially concerning the missile strike on Syria and the verbal threats from North-Korea. Was that drop to $50 dollar, however, a sign of a further decline in the coming months if geopolitical tensions do not heat up further?

Air-Conditioning On, Please!

Regarding US oil production, experts argue that US oil production will continue to increase in the near term. The current oil price is still profitable for many producers, something that would not have been the case with prices at $45 dollar or less. From that perspective, we can expect persistent downward pressure on the oil price.

Another question that oil traders are anxiously trying to answer is whether OPEC countries will carry forward their agreement to lower oil production. This might become, however, an unimportant matter in the bigger picture.

After all, if the OPEC countries agree to lower production levels or agree to lower production even further, then the oil price, as it did in December last year, might experience an initial stimulus, but it is to be expected that the other, non-OPEC countries will increase production to profit from that higher oil price. Something which, just as in December last year, will push down oil prices. And if OPEC countries do not extend their agreement, then that could also lower oil prices. In short, it is possible that, no matter what the OPEC decides, the oil price will not rise significantly for a sustained period of time.

Having said all this: there is a factor at play which could lead to an increased demand for oil in the coming months, especially from the US.

The demand for oil in the US depends in large part to how many cars are being driven in the US and how many miles an American drives on average. The latter mostly depends, in turn, on how many Americans have a job; low unemployment means that many people need to travel long distances to commute to work. Unemployment in the US is nowadays almost 4 percentage points lower than before the crisis. The number of miles driven has increased in every single month in 2016.

That low unemployment has, in turn, also increased confidence among Americans. Consequently, many Americans decided to buy a new car, which in many cases was a gas-guzzling SUV (also because gasoline and diesel were cheap). The sales of SUVs have reached an all-time record last year, just as sales of light trucks.

All the above together means that the number of miles driven will only rise in the US in the coming months and will lead to an increasing demand for gasoline; mainly due to an increase in the number of miles driven, but also due to the type of car that Americans use in their daily commute.

Add to that the fact that summer is approaching fast, which means that millions of air-conditioning units will be working full-time, and it is not difficult to imagine that the demand for crude oil could rise considerably.

Whether or not this is enough to stimulate oil prices, is uncertain. As I said before, we can expect an increase in oil production that counters any such increase. And if there is any urgency, the US government can always dip into its historically high strategic oil reserves.

In case oil prices indeed stop increasing, then the recent upward pressure on inflation would lessen, which in turn could be a reason for the Fed to take it a bit easier with regard to its scheduled rate hikes.

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