Oil price rise will drive inflation upward
Oil prices are on the up. Since early June, Brent crude has surged from just over $100 to reach $108.7 per barrel last week – a three-month high. West Texas Intermediate, the US oil benchmark, meanwhile hit $107, a level not seen since March 2012.
Rising energy costs hit consumers and firms, hinder growth and also stoke up inflation, especially in an oil-importing country like the UK. It’s particularly concerning that crude is rising despite growing evidence that the global economy is once again starting to slow.
The International Monetary Fund just downgraded its US growth forecasts. The largest economy on earth will expand 1.7pc this year, the Fund said last week in its World Economic Outlook, having predicted 1.9pc growth back in April. That’s sharply down from US growth of 2.2pc in 2012.
A major drag on the world economy is the Eurozone, which remains locked in recession and looks increasingly unlikely during 2013 to improve on last year’s abysmal 0.6pc GDP contraction. Lou Jiwei, China’s Finance Minister, has also acknowledged that the world’s second-largest economy could undershoot its 7.5pc growth target in 2013.
A further significant negative is the prospect of, as the IMF puts it, “tighter financial conditions if the anticipated unwinding of monetary policy stimulus in the US leads to sustained capital flow reversals”. In other words, recent volatility on financial markets, sparked by concerns the Federal Reserve will cut back its $85bn-a-month money printing habit, is impacting the real economy. Fears are growing that the “tapering” of American QE will spark a rise in interest rates, not just in the US but across the Western world, doing damage to highly indebted households and firms.
Central bankers issue “forward guidance”, telling us rates will stay low for “a long time to come”. But worries that debt service costs will rise anyway are weighing on consumers and companies alike, causing many to hesitate before spending and investing. The prospect of QE ending, then, is another reason why the IMF says “downside risks to global growth prospects still dominate”. While its estimate for the UK rose slightly, the Fund has slashed its global growth forecast for 2013 to 3.1pc, down from 3.3pc three months ago.
As the global economy has deteriorated, oil prices have risen. Ordinarily, a growth slowdown would cause a fall, with global energy demand expected to slow or, more accurately, to rise at a slower rate. At the moment, though, there are fears on the supply side, with traders worrying about geo-politics, particularly in the Middle East.
Although Egypt produces very little oil, the military’s ousting of President Morsi has raised concerns about the disruption of shipments from the Middle East to Europe. The Egyptian-controlled Suez canal facilitates the transit of around 10pc of global seaborne crude exports daily. The Suez-Mediterranean pipeline is also among the world’s most important energy arteries.
Concerns about Egypt come on top of supply disruptions in Nigeria, Libya, Iraq and Iran – where sanctions on oil shipments are binding tighter. In total, OPEC production fell by 370,000 barrels, around 1.3pc, in June. Such supply issues have helped push up oil prices in recent weeks.
What about shale oil, I hear you say? Well, its true that by extracting hydrocarbons using the hydraulic fracturing – or “fracking” – of underground shale formations, America’s energy industry is now employing millions of extra workers and helping a manufacturing recovery through cheap energy.
When it comes to natural gas, shale is indeed a “game-changer” for the US. American gas production has risen from 580bn cubic metres in 2009 to 620bcm in 2012, with shale now accounting for 30pc of US gas output, up from 1pc in 2000. That’s significant, given that America produces around a fifth of the world’s natural gas.
In terms of oil, though, shale is far less significant. Yes, shale production, behind a ban on most US crude exports, has allowed America to build up a large stockpile, so keeping local prices below those on world markets. Yet, for all the triumphalism, the amounts produced have been pretty tiny in the global context.
The exploitation of “tight” oil formations in North Dakota and Texas have certainly helped US shale – plus Canadian tar sands – drive a rise in North American production averaging around 500,000 barrels per day over the past three years, once falling output at other North American fields is included.
This sounds impressive and visitors to booming oil regions such as Bakken and Eagle Ford will see a lot of activity. Yet given that the world economy consumes upwards of 90m barrels a day, a 0.5m increase – equal to the oil production of Ecuador, OPEC’s smallest producer by far – is not going to re-draw the energy map of the world.
This is particularly true at a time when geo-political concerns are looming large. Supply disruptions in the Middle East and North Africa have “already provided a major offset to rising North American supply and may continue to do so,” said the International Energy Agency, the oil-importers think tank, in a report last week.
Recent increases in North America oil production are actually too small even to replace production falls registered by other non-OPEC producers. Back in 2002, producers outside the exporters’ cartel pumped 36.1m barrels of oil a day. Today that total is just 35.1m. What’s more, the current non-OPEC number would look a great deal worse had Russia (which remains outside OPEC) not raised its production from 7.8m to 10.5m barrels over the same 10-year period.
The bigger picture is that in each of the last four years, the annual rise in oil production due to shale and tar sands combined had been totally blown away by the increase in oil demand from the rest of the world – not least the fast-growing oil-thirsty emerging markets. Such nations are now growing slower than they were, but the IMF predicts they’re still on course to expand on average by 5pc or more over the next two years. All that smelting, building, driving and consuming needs an awful lot of oil.
Even if Western oil demand falls over the coming years, then, the emerging giants of the East are sucking up crude so fast that global demand will keep rising, and at a rate much faster than “fracking” could hope to meet. Once subsidies are removed, shale oil is anyway far from cheap, not least because it requires the continuous drilling of small wells, rather than the long exploitation of big wells. So constant – and costly – drilling is needed just to maintain shale output, let alone increase it. Let’s not kid ourselves, then, that shale oil will bring the Western world “energy independence” or usher in an era of cheap energy. It won’t.
In 2010, oil prices averaged $79 a barrel. That figure rose to $111 in 2011 and $112 in 2012 – with triple-digit oil becoming “normal”, as some of us predicted it would. This year, too, a combination of rampant demand from the emerging markets and geo-political unrest will keep crude around the same elevated level.
In May, UK CPI inflation was 2.7pc, up from 2.4pc the month before. On Tuesday, new numbers will show inflation rising again in June, reaching at least 2.9pc, perhaps more. With the pound hitting a three-year low against the dollar last week, so raising import prices, and crude unlikely to relent over the coming months, we can expect a lot more inflation to come.