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In May we wrote that geopolitical factors posed an upside risk to oil prices. Those risks have materialised. Last week the oil price reached $82 a barrel, up 40% over the last 12 months and the highest level in almost four years. Some analysts are warning of a spike above $100.
Three factors are at work.
First, following America’s withdrawal from the 2015 nuclear deal the US will reimpose sanctions on Iran in November and has threatened secondary sanctions on countries that buy Iranian oil. US security advisor John Bolton said the US could reduce Iran’s oil exports to zero. Iran was the fifth largest producer of crude oil last year, accounting for 5% of the world’s total crude oil production.
Second, Venezuela’s oil output has slumped, a victim of the country’s chronic economic mismanagement and US sanctions. Venezuelan oil output is running at just half the level of late 2015 and seems likely to fall further.
Third, the major oil producers, led by OPEC but including Russia, Mexico and others, have decided against further increases in oil output. In doing so the producers have turned a deaf ear to President Trump’s increasingly bellicose demands for OPEC to raise output. (Mr Trump recently tweeted: “the OPEC monopoly must get prices down now… [and] stop ripping off the rest of the world…I don’t like it”.)
Higher oil prices transfer resources from oil consuming nations to oil producers. For Western nations this means less spending and slower GDP growth. Sharply higher oil prices have, for this reason, preceded most major recessions of the last 70 years. In July, ratings agency Moody’s said the rise in oil prices over the first half of the year contributed to a rise in the probability of a US recession materialising by 2020 from 28% to 34%. The higher oil price is also likely to weigh on growth in the euro area and in oil consuming emerging market economies next year.
While geopolitical developments have helped boost the oil price, supply and demand fundamentals point to longer term downside risks.
Global oil supply has been revolutionised by rising US production. Fracking has helped double US crude production in the last ten years, making the US the world’s largest oil producer last year. In time, higher oil prices boost exploration and investment, just as the sharp decline in prices in 2014-15, hit investment. The number of rigs exploring for or developing oil or natural gas in the US and Canada has risen almost three-fold in the last two years. Improvements in horizontal drilling and hydraulic fracturing have brought costs down sharply. Global levels of capital investment in oil and gas have also been rising for the last year.
Meanwhile the crucial nature of Saudi Arabia’s relationship with the US may yet result in the Kingdom raising production to offset falling Iranian output.
On the demand side, slower global growth will soften demand for oil and, in time, weigh on oil prices.
It’s for these reasons I am inclined to think oil prices will be lower in a year’s time than they are now.
PS: Last year we wrote about the work of Nobel Laureate Angus Deaton and Princeton economist Anne Case who shed light on the remarkable decline in the life expectancy of white, working class Americans. Last week data from the ONS revealed life expectancy in the UK has stopped improving for the first time since 1982, when figures began. A spokeswoman for the Department of Health and Social Care said “Recent trends in life expectancy and mortality in the UK can also be seen in a number of countries across Europe, North America and Australia.”
Ian Stewart is a Partner and Chief Economist at Deloitte where he advises Boards and companies on macroeconomics. Ian devised the Deloitte Survey of Chief Financial Officers and writes a popular weekly economics blog, the Monday Briefing. His previous roles include Chief Economist for Europe at Merrill Lynch, Head of Economics in the Conservative Research Department and Special Adviser to the Secretary of State for Work and Pensions. Ian was educated at the London School of Economics.