Higher Oil Prices Are an Increasing Headwind

Oil prices have increased since the lows in early 2016, and the upward trend has intensified since 2017. It is no oil crisis, and we are certainly nowhere near the peak of $145/barrel in June of 2008. Remember filling up your SUV back then?

We care because higher oil prices are yet another headwind to economic growth, a headwind that is getting stronger. Outside of the obvious impacts of higher gas prices and the cost to heat your home in winter, higher oil prices work their way through the economy as petrochemical cost increases and transportation expenses, and eventually end up causing higher inflation. We know the Fed likes to call energy and food price fluctuations transitory, but the flu is also transitory and certainly not pleasant!

Of course, higher oil prices help oil producing countries like Saudi Arabia and Russia. Though the U.S. is certainly producing more oil these days, we are still a net oil importer.

Chart: West Texas Intermediate (WTI) Crude Oil Price

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Unfortunately, on balance higher energy prices are an economic drag and we can see these headwinds increasing. As a basic commodity, oil should settle at the marginal cost of production, which many think is around $65 per barrel. But in the short term it’s all about supply and demand, and for the foreseeable future the concern is about less supply and a continued increase in demand.

There are three major areas of concern around supply. Sanctions imposed on Iran starting in November will reduce supply from this large oil producer, Venezuela production continues to fall rapidly due to political turmoil, and supply growth in the U.S. may be less than expected due to pipeline and technology issues.

Demand growth is still expanding around the world, mirroring strong yet diverging world GDP growth. The U.S. is growing above trend, China’s growth is lower but still likely above 6%, Europe is still positive and Japan, while weak, is still relatively stable.

Continued growth in demand with tighter supplies would not be so big an issue if oil inventories were overflowing and there was plenty of excess production capacity in Saudi Arabia, the world’s swing producer. Alas, this is not the case; Saudi Arabia is already producing at record levels, with less excess capacity after years of lower prices and less investment. So, with supply constrained and demand still growing, the way to bet is for oil prices to go higher.

Time to fill up your gas tank!

Sources: Energy Information Administration, Bloomberg, the Financial Times, International Energy Agency