Every time Americans stop at a gas station to fill their tank, they get another lesson in economics and geopolitics.
The average price of a gallon of gasoline is currently at $3.85 a gallon, according to AAA, down from $4.26 a month ago but still $0.70 higher than one year ago. Drivers in California need to fork over an average price of $5.28 a gallon.
While energy prices are still below their most recent highs, they’ve been ticking upward again more recently. The price of a barrel of West Texas Intermediate (WTI) crude oil has jumped by around $10 since mid-Augst to $97 as of this writing.
Where will oil prices go now? The answer is complicated by conflicting narratives pointing in opposing directions.
With the Federal Reserve pushing higher interest rates and the global economy skulking into recession, the price of oil should decline. At the same time, lower output by oil-producing countries—including Saudi Arabia, Russia and even the United States—supports higher prices.
No one knows how these crosscurrents will resolve in the near future.
Oil Prices and a Looming Recession
Life was different when oil pushed past $100 per barrel in early March 2022. Back then, the Fed was still buying long-term bonds, and hadn’t quite pulled the trigger on quantitative tightening.
The cost of credit was much cheaper, with the federal funds rate roughly 2.25 percentage points lower. The 30-year fixed rate mortgage was hovering around 3%, compared to more than 5% now.
Since then, the Fed has begun raising rates dramatically to crush historically high inflation. In a recent speech at the Jackson Hole economic summit, Fed Chair Jerome Powell reaffirmed the Fed’s dedication to getting inflation back to its 2% target, even if the broader economy suffers.
“Reducing inflation is likely to require a sustained period of below-trend growth,” Powell said. “Moreover, there will very likely be some softening of labor market conditions.”
This comes after the economy contracted in the first six months of the year, a common definition of recession.
The price of oil is viewed through the lens of future global economic growth: Higher prices can signal investor belief that consumers will spend more, while falling prices demonstrate a conviction that demand will reduce.
That pessimism is what drove oil prices lower in the past few months. Recent developments, though, especially out of Saudi Arabia and Russia have complicated that narrative.
OPEC Production Cuts Mean Higher Oil Prices
One of President Joe Biden’s principal foreign policy endeavors has been to convince Saudi Arabia and the rest of the organization of petroleum exporting countries (OPEC) and its allies to increase oil production.
“The idea that Russia and Saudi Arabia and other major producers are not going to pump more oil so people can have gasoline to get to and from work, for example, is not right,” Biden said at a G-20 meeting in November 2021.
Biden made his appeal directly to Saudi officials during a trip to the gulf state in July. So far, they’ve failed to make progress.
Recent comments from Saudi officials have led market analysts to believe that OPEC’s most important nation is in no mood to dramatically increase production in the face of lower economic growth, and would even reduce output.
“OPEC+ stated that they are open to production cuts to support the market, in the event we see a global recession,” said Noah Barret, lead energy analyst at Janus Henderson Investors.
The oil producing nations may also scale back supply in the event of a nuclear weapons deal between the United States and Iran, which would allow the Persian state to sell more oil on the open market.
Russia’s War on Ukraine and the Price of Oil
While Saudi Arabia is the world’s second largest producer of oil, Russia is in third place.
That reality was thrown into stark relief after Russia invaded Ukraine in late February, causing crude oil prices to briefly rise above $100 a barrel, before ultimately touching $120 a barrel a few months later as the U.S. and its western allies imposed crippling sanctions on Russia.
Energy giants such as Shell, BP and Exxon all pulled out of Russian energy deals, while the Biden administration has announced a ban on importing Russian oil and other petroleum products, which represents about 8% of U.S.-bound crude shipments.
But Russia has not stood idly by, instead locating new buyers, especially in Asia and even the Middle East, for one of its most important exports.
“To date, Russian export flows have been resilient,” said Barret. “Russia may have to sell its oil at a material discount, but the oil is still finding its way into global supply.”
Fresh European trade restrictions are scheduled to go into effect this winter. If they are successfully implemented, this could result in less supply on the market, and therefore higher prices. More expensive energy coming as temperatures drop in Europe could further aggregate already simmering geopolitical tensions.
U.S Oil Production Slow to Respond
In the U.S., oil producers aren’t in a hurry to dramatically expand production.
“U.S. oil production continues to move higher, but at a fairly modest pace,” said Barret. “We haven’t seen upstream producers materially increase production targets above their initial full-year guidance.”
For instance, the U.S. produced 11.5 million barrels of crude oil a day in May 2022, according to the U.S. Energy Information Agency. While that’s 200,000 more than a year ago, it’s roughly half a million barrels a day less than in 2019.
Why? For one thing, they don’t want to invest heavily on new wells only to see supply increase, prices decline and their profits dwindle.
This was a major theme of the fracking boom that helped propel the U.S. to become the number one global oil-producing nation over the last decade and a half. Many companies went bankrupt as they overextended themselves building out infrastructure, only to see oil and gas prices plummet on greater and greater supply.
Meanwhile, there’s a large push by some of the world’s largest institutional investors, including BlackRock, to steer investment toward companies with low levels of environmental, social and governance (ESG) risk. That’s moved money away from oil and gas producers when those dollars would help increase production.
“Underinvestment because of ESG is one of the confluence of issues causing the price to increase,” Jack McIntyre, a portfolio manager at Brandywine Global, said.
A lack of supply is supporting higher prices, while weakening economies across the globe is pushing prices lower. If the Saudi’s make good on their comments to further manage supply, Barret expects oil prices to toggle between $80 and $120 a barrel.
That is, until the next development occurs.
Source: https://www.forbes.com/advisor/investing/high-oil-prices/