Since the start of the month crude oil prices have risen to the highest level in seven years with the sabre rattling over Ukraine and a waning of the latest Covid wave fanning demand. But although more short-term increases seem to be on the cards – demand is strong, and OPEC is increasing production at a lower rate than expected – the medium-term picture is worsening.
High inflation and a series of interest rate hikes not only in the US but also in Europe and in the UK are expected to dent oil demand later in the year. US consumer prices have risen by over 4% in the last two years, exceeding the Federal Reserve’s long-term target of just over 2%. The US central bank is expected to opt for a series of rate increases starting with a 50bp hike in March followed by four 25bp hikes in May, June, September and December. If inflation remains high this process could continue into next year.
The Bank of England is travelling down the same road and while the ECB is somewhat holding back compared with the Fed, it is also mulling potential rate hikes.
What does this mean for oil prices?
The upshot of the rising interest rates will be slower economic growth across the board, potentially setting the stage for the next cyclical downturn in oil prices.OPEC’s plans seem to be a step behind the new economic picture. The cartel said this week it expects strong oil demand in 2022 as the global economy pulls out of the pandemic-induced slowdown. It forecast world oil demand to rise by 4.15 million barrels per day (bpd) this year following a steep rise of 5.7 million bpd in 2021. The group is in the process of ramping up production to meet the current increased demand but has done less in December and January than it said it would.
Once this production starts arriving in the market it will meet with the new reality of demand affected by the significant scale of monetary tightening. Later this year households will feel more pressure from inflation while also facing higher outgoings in the form of mortgages and loan repayments. They are likely to cut spending not only on petrol and travel but also goods across the board which will affect not only retail demand but also demand from industrial production.
What does this mean for traders?
One way of playing this market is through further forward contracts. At present November, December, January and February are trading at a discount to today’s price of close to $10 a barrel. While WTI is trading at $90.25/bbl, the December WTI contract is quoted at $80.81 and January at $79.87/bbl. Backwardation – the gap between the current contract and year-end contract – is currently at the highest level since late 2013.
Backwardation on Brent crude futures is a little bit less pronounced, possibly because Brent prices corrected down on talks of a deal with Iran that could see fresh inflows from the oil producing country. April Brent crude is trading at $91.72/bbl while December is quoted at $83.97/bbl.
For the moment, the exuberance over the Covid recovery and the Russia-Ukraine-NATO headlines are obscuring some of what is unfolding in the oil market, but over the coming months the hard facts of inflation and interest rates will begin to weigh more seriously on prices.
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