Sometimes a headline says it all. And that was certainly the case with Thursday’s Financial Times headline. It shouldn’t have been a surprise to anyone who has been following the oil market. But it clearly did surprise a lot of people.
We first highlighted the possibility in July, suggesting that “Oil prices head into a warning triangle, again“. And the risk was even more obvious earlier this month when we suggested “OPEC+ risks losing control of oil markets“.
The market’s surprise, and the FT’s decision to headline the story, highlights investors’ worrying lack of attention to critical developments in the world’s most important commodity market.
THE MARKET PREFERRED TO BET ON INTEREST RATE MOVEMENTS
For the past month, investors have instead focused on whether the US Federal Reserve would cut rates by 0.25% or 0.5% at its September meeting. On the day of the decision, the bet was 2 : 1 on 0.5% as CNBC reported.
Obviously, this was a great game for traders, who know how to play volatility to their advantage. But otherwise, the decision was really just a ‘feel good’ factor for voters ahead of the election:
- Interest rate changes typically take 12 – 18 months to make their full impact on the economy
- So we are only now seeing the full impact of the Fed’s March 2022– July 2023 rate rises, which took interest rates from 0.25% to 5.25%
- Against this background, this month’s cut is unlikely to have much impact outside of Wall Street
OIL PRICE MOVEMENTS HAVE MUCH MORE IMPACT ON ORDINARY CITIZENS
Brent Crude Futures
Advanced Charting
The price of oil is far more important to Main Street. And as the Wall Street Journal chart confirms, this has been declining for the past 3 months.
Importantly also, as the US Energy Information Agency (EIA) reports, gasoline prices were falling over the peak summer driving season. At the end of March, they averaged $3.67/gal, but were down 13% last week to average $3.19/gal.
And now, of course, we can expect prices to fall further, and probably faster, as OPEC+ aims to reclaim lost market share.
This is a remarkable development, given that Israel is potentially about to launch another war in Lebanon. The last time this happened, in July 2006, Brent prices jumped from $67/bbl to $78/bbl between June-August, before falling back to $51/bbl when it ended.
But this time, prices have been falling even though the risk is still growing.
A COLLAPSE IN OIL PRICES COULD WELL BE THE CATALYST FOR DEFLATION
Consumer Price Index
What happens next is obviously the key question. There is clearly a risk that Iran will intervene in the war and potentially close the Strait of Hormuz. As the EIA notes:
“The Strait of Hormuz is the world’s most important oil chokepoint because large volumes of oil flow through the strait. In 2022, its oil flow averaged 21 mbd, or the equivalent of about 21% of global petroleum liquids consumption.”
If that happened, then oil prices would likely soar – almost certainly to $100/bbl, and probably much higher.
But if Iran stays on the sidelines, then prices will likely come under pressure, given the OPEC+ decision. They might well fall back to $30/bbl, as in the past, before this process finished.
In turn, this could well be the catalyst for a move into deflation as in 2009, as the St Louis Fed chart illustrates.
This time might well lead to a much more prolonged period of deflation, and major changes in consumer behaviour:
- Most of us have only ever known inflation, so we naturally assume it makes sense to buy today, if possible as prices will be higher tomorrow.
- But deflation would reverse this pattern. With deflation, it would make sense to wait and buy tomorrow, as prices will then be lower.
Oil market developments therefore need very careful attention. If prices do now fall below $50/bbl, then central banks will likely rush to make major cuts in interest rates. And that will make deflation even more likely.