Last week, WTI for November delivery passed the $76 a barrel mark. And since September, speculation has been rife that oil could top $100 a barrel in due course. If oil prices do continue to rise, that’s going to have very different effects for the US and Europe, increasing the divide in economic fortunes and fuelling greater policy divergence.
The big picture
OPEC’s reluctance to increase output at the behest of the Trump administration and signs of accelerating supply losses from Iran have combined to create a bullish mood. No one is going to be able to fill the gap left by Iran as the Trump sanctions regime tightens. Moreover, the economic crisis in Venezuela has left that country ill-equipped to maximize oil production. And at present, the Category 4 Hurricane Michael has already disrupted Gulf of Mexico oil supply with oil production down 40% and natural gas output down 28%.
The big losers: The euro area, the UK and Japan. They are big oil importers. Bank of America Merrill Lynch says “We estimate that growth in these countries would be depressed by 0.2-0.5pp next year” if oil prices were to rise to $100 a barrel at the start of 2019 and remain at that level throughout the year. That’s because of the extra money consumers would have to fork over to pay for oil.
The US, on the other hand, would be a winner. US shale is the biggest source of new global supply. And so, rising prices would greatly benefit that industry. Moreover, it could also spur additional capital investment which would further bolster US GDP.
$100 is not a level that would necessarily induce demand destruction as the $150 level did a decade ago. Moreover, depressed business sentiment in Asia, due to the US-China trade war, may translate into a loss of demand that keeps oil from rising much further from present levels.
Overall, though, at present there is a lack of spare capacity in supply. And that puts upward pressure on price.
The monetary reaction
With the US already leading the charge in terms of global growth in the largest developed economies, inflationary pressure from rising oil prices would only further accelerate the Fed’s rate increases.
I don’t see the Fed’s actions as particularly worrisome yet because the pace of hikes has been slow enough that credit stress has been relatively weak. Moreover, increased rates increase interest income, as the private sector is a net receiver of interest. And that bolsters demand.
However, going forward into 2019, I would expect the credit stresses to increase. We are already seeing signs in the housing market that the Fed’s rate hikes are having a dampening effect on new home demand.
Elsewhere, the increase in inflation may cause central banks to act. But I suspect the damper on growth from rising oil prices will be the driver of policy more than fears of inflation. So, at the margin, we should expect the European central banks and the Bank of Japan to proceed more cautiously if oil prices rise. That is going to increase policy divergence and could have a negative impact on US dollar debtors who primarily earn non-US dollar revenue.
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