The oil price has risen 70% in the last 12 months, from 45$/ barrel for Brent in June 2017 to around 80$ in May 2018. Thus, after three years of low prices, crude has returned to levels not seen since the end of 2014. What are the forces behind this increase in oil price? Could it damage the world economy? The analysis of CaixaBank Research follows.
The factors behind the rise in oil prices
At the beginning of 2018, the oil market found itself in a situation where supply persistently exceeded demand and, in this way, a significant cushion in oil reserves had accumulated. Even so, the price of Brent had recovered from the falls of 2014 and 2015, and had stabilized at around 55$/barrel.
However, from June 2017 oil prices began a sharp upward move, driven by both supply and demand. On the supply side, the agreement to cut production among OPEC members and their allies managed to contain, and even reduce, world oil supply. What’s more, the cuts in crude production exceeded what had been agreed. Given this moderation in supply, it was thought that’s US production would revive strongly and contain the price of Brent between 50 and 60$. However in recent quarters US oil infrastructure has been limited by bottle necks and has been unable to compensate for OPEC cuts.
The containment of supply has been accompanied on the demand side by a vigorous advance in the world economy, exceeding expectations and forcing a significant upward move in predictions for growth. Finally, the combination of these supply and demand side dynamics have significantly reduced the cushion in oil reserves, which could explain the greater volatility of oil prices, and their renewed sensitivity to geopolitical risk. In this sense, it is probable that the recent reintroduction of economic sanctions against Iran have also contributed to the rise in crude prices (not only through the direct impact they will have on oil exports, but also through increasing the risk of geopolitical conflict in the Gulf region).
Despite the consensus over the role played by all these factors, there is disagreement over their relative importance, and estimations vary significantly depending on the methodology used. For example, the New York Federal Reserve disaggregates the fluctuations in oil prices into supply and demand factors from their relations to the universe of financial variables. Their results suggest that demand would account for 50% of the price increase, while supply would account for 20% (the model attributes the remaining 30% to other factors which it can’t explain). On the other hand, working from the analysis of oil production and consumption in the past, as well as the accumulation of reserves (which reflects expectations about the future balance between supply and demand), the ECB has recently estimated that supply side factors were responsible for over 60% of the increase, while global demand has accounted for 30% of the rise and the reduction of reserves has tended to gently push prices down.
The consequences for growth
The impact of rising oil prices on global growth will depend on two elements: i) the factors responsable for the movement (supply, demand and others) and ii) the balance between the positive impact on the economies of crude exporters and the negative impact on the importers of crude. Traditional estimates implicitly assume that the negative consequences on oil importers (with a greater marginal propensity to consume) has been more significant than the positive impact on the incomes of oil exporters. However, while these estimates focus on analysing the consequences of reductions in oil supply, we have just seen that demand side factors are also relevant and, therefore, can mitigate the negative impact of the oil price rise.
Finally, in addition to the mitigating effect of demand, three other changes in the traditional transmission mechanisms have occurred. Firstly, oil has lost importance in global supply chains, both because of the reduced intensity of energy in GDP and the reduced contribution of oil to total energy consumption. Secondly, currently the oil exporting economies have smaller fiscal cushions, and therefore their tendency to spend additional oil incomes may be greater. Lastly, the irruption of the shale sector in the US has meant that a significant part of the American economy is now benefiting from the higher oil prices.