Oil and Inflation in the Monitor
co-written with RGE Monitor’s Analysts
Oil prices continued to dominate the headlines in the past week and spiked above $135 a barrel intra-day on Thursday. This is about twice the price of May of last year (about $67 per barrel). The oil price juggernaut continues to roll upward to real and nominal all-time highs, pushing forecasts for the average 2008 oil price higher and higher. Observers point to several factors responsible for the price surge this year – speculation, fundamentals, low interest rates, dollar weakness, subsidies, hoarding, and hedging against inflation and financial crisis.
With limited surplus capacity and little investment in real terms, supply pressures may persist putting an upward pressure on today’s prices. The IEA, which usually tracks demand, not supply, announced that it may scale down long-term supply forecasts, suggesting that both OPEC and non-OPEC supply may increase at a slower pace than previously thought. Furthermore, much of OPEC’s surplus capacity is in heavier grades of oil, which sells at a discount. RGE’s Mikka Pineda and Rachel Ziemba recently surveyed the “Drivers of the Oil boom”
There may be signs that high oil and product prices are having an effect though, at least in industrialized countries, which still account for the bulk of demand. U.S. imports of crude oil have been falling for several weeks and gasoline purchases are being watched closely for any decreases. Yet the recent output increase from Saudi Arabia is all bound for U.S. customers. See “Will U.S. Oil Imports Keep Falling?” and “Saudi Arabia as the Central Bank of Oil: How Significant Are New Supplies?”
Yet, so far slowing demand from OECD countries has been offset by persistent demand growth from emerging markets, especially fast-growing Asian and oil exporting economies. Many of these countries subsidize fuel prices, meaning that consumers are mostly sheltered from the price shock even if producers and government budgets are not. On the RGE Analysts EconoMonitor, Rachel Ziemba suggested that the persistence of price caps may inject uncertainty into the market and lower incentives to seek out alternative supplies for domestic markets. Yet, a limited price increase, such as the one that Indonesia just introduced, might result in the double whammy of rising prices while still swelling fiscal budgets. See “Subsidies Fuel Rapid Oil Consumption Growth in Oil Exporting Countries” and “Are Oil Subsidies Getting Too Costly For Asia?”
The lag between inflation and slower growth has been longer than expected and has revived fears of stagflation. Forecasters envision the oil juggernaut will lose momentum later this year on a global demand slowdown predicated upon the economic fallout of the credit crisis and/or the self-limiting effects of high inflation. Indeed, the oil futures curve has moved into contango, which tends to drive oil inventories higher and spot prices lower. Perhaps a sign of higher gasoline prices crimping demand, Americans are driving less than last year. On the other hand, the Baltic Dry Shipping Index and Dow Jones Transportation Average hit all-time highs last week, suggesting resilient global demand will not slow enough to dampen oil prices significantly this year. Historically, it took 4 years for U.S. consumption to decline after the 1979 oil shock – see “Oil and Inflation: A Negative or Positive Correlation?”
Meanwhile, persistent high oil prices have intensified unease over inflation. Risky assets enjoyed a breath of optimism since the March 17 Bear Stearns rescue, but the ‘worst is over’ optimism about the economy is now fading – this time due to higher inflation rather than slowing growth. Weakening U.S. consumer demand undercuts the ability of producers to pass on cost increases to consumers, but inflationary pressures are building throughout the production chain; thus, some mild pass-through to core consumer inflation may be inevitable. However, thanks to seasonal adjustments, the large share of falling housing prices and the exclusion of food and energy prices from core inflation indices, the official U.S. inflation figures look benign compared to what consumers actually experience in the U.S. and the rest of the world. EU and emerging markets suffer higher inflation figures due to the inclusion of processed foods and the higher share of food and energy in core consumer baskets. Diesel, the fuel of choice outside the U.S., fetches higher prices than gasoline. These countries are also more susceptible to wage hikes than the U.S. due to stronger labor unions and policies. Fortunately, EU inflation looks likely to have peaked and will moderate (albeit only slightly) this year on base effects. Emerging markets, on the other hand, face an uphill battle with inflation as diesel, the fuel of choice for industrial and some consumer applications, fetches higher prices than gasoline with the oil-diesel crack spread at all-time highs.
Granted, inflation today in developed countries is far from the double-digit Great Inflation of the 1970s – second round effects have yet to appear globally (with exceptions such as Germany and the Middle Eastern Gulf). Nonetheless, though the lack of second round effects may keep current inflation trends as temporary, it makes them painful because wages fail to keep up with higher consumer prices. Moreover, trade barriers and hoarding threaten to turn a demand-side shock into a supply-side shock to food and fuel prices, sustaining higher inflation for longer. Regardless of the source of shock and the dissipation of the food price shock, a continued rise in oil prices – despite slowing economic growth – can render the feeling of stagflation among consumers, if not in official statistics. Perceived inflation, corroborated by statistics or not, can feed into inflation expectations that drive prices higher (including oil futures prices) and, eventually, consumer demand lower. Furthermore, developed countries are not immune to inflation in developing countries if developing countries pass on cost increases through export prices and maintain a high level of oil demand growth.
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