Regardless of your view on an energy transition, escaping this economic reality is impossible: We are going to be fueled by crude oil for the foreseeable future. That may change someday, but not today.
The ebbs and flows in crude oil pricing significantly impact global economies. Rising crude oil prices have recently been gently nudging headline inflation rates higher and compelling central banks worldwide to reexamine their policies.
In September, Saudi Arabia and Russia agreed to extend their 1.3 million barrels per day production cuts through December. Some analysts believe this will result in a market deficit of more than 1.5 million barrels per day in the fourth quarter of 2023. While OPEC+ decided to review their decision monthly, the extension helped to power both Brent and WTI crude markets higher, which complicates things for the U.S. Federal Reserve and other global central banks. These institutions are concerned that a sustained rise in the price of crude oil could derail some of the progress they’ve made on inflation. Energy prices are a nuanced part of inflation that central banks cannot directly control.
So, what are some of those nuances, and how do they send ripples across economies, affecting inflation and central bank policies?
Understanding the correlation between crude oil prices and inflation starts with understanding that crude oil is quite literally a fuel of the global economic engine. The price of oil can influence the cost of energy, transportation and production, subsequently affecting the prices of goods and services. This interconnectedness means that a surge in oil prices inevitably contributes to inflation, although to what level is a source of debate amongst strategists, economists, and their various models. What is not a source of debate, however, is a meaningful jump in the price of crude oil may necessitate adjustments in monetary policies by central banks.
Crude oil's impact on inflation comes from two primary sources.
Cost-Push Inflation:
Rising crude oil prices are a textbook precursor to cost-push inflation. Many analysts are quick to point out that the percentage of a consumer's total budget spent on energy (including at the gas pump) is only in the range of 3% to 6%. But this isn't the only place where oil might affect the consumer budget. Higher oil prices escalate production costs, increasing prices for goods and services, thus stoking consumer inflation. Industries heavily reliant on oil, such as transportation and manufacturing, particularly feel the pinch, transferring the additional costs to consumers.
Demand-Pull Inflation:
Consumers are also susceptible to demand-pull inflation. A simple example would be that as the cost to manufacture and transport a new refrigerator starts driving the price of refrigerators higher, consumers decide to rush out and buy one now before the price increases even more. But it's not just consumers. When oil-producing countries experience a windfall due to elevated oil prices, their increased purchasing power can fuel additional demand-pull inflation on a global basis. This rise in sum-total demand, outpacing supply, exerts upward pressure on prices, contributing further to inflation, and the circle continues.
This inflationary impact can generate a global central bank response, especially when combined with current and persistently high inflation. Central banks may try to adjust through higher rates, which can hurt small businesses and consumers who may rely to a certain extent on short-term loans for necessary spending. They could also be much more aggressive on reducing their balance sheet, which reduces money supply and slows growth.
Higher crude oil prices can also work to slow an economy when combined with higher rates. Higher gasoline prices for consumers may result in reduced disposable income for households, potentially dampening consumer spending on other goods and services. It may also increase reliance on short-term loans, such as credit cards and home equity lines of credit, loans which now may be set at higher rates than they were in the recent past. Since consumer spending accounts for a significant portion of economic activity, a decline in this can affect corporate revenues and stock prices.
There is some hope in this cycle, however, as OPEC's crude oil production climbed in August by an average of 113,000 barrels per day, according to the group's latest monthly oil market report. The production boost was primarily led by Iran and Nigeria, both exempt from production quotas.
Also, crude oil production in the United States surpassed 13 million barrels a day during the first week of October, which is higher than its been since March 2020. This record production is coming just as we enter the slowest seasonal demand for crude oil.
If other oil-producing nations pick up the slack, and demand doesn't spike beyond expectations, central banks may dodge a bullet directly at the progress they’ve made so far on inflation.
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