Oil prices are at a seven-year high, while demand for coal and gas is outstripping supply, causing energy prices to skyrocket. Lyxor’s Senior Cross-Asset Strategist Jean-Baptiste Berthon looks at the multiple causes for this energy price spike, and the long term consequences.
What is causing the spike in energy prices?
Supportive demand and supply conditions are combining to push oil prices higher. On the demand side, the reopening is in full swing in Europe, the US economy is accelerating amid Covid vaccination progress and travel is restarting.
Oil prices are also getting a fillip from the unprecedented spike in gas and coal prices, leading industries and power generators to switch to oil when possible.
Low natural gas inventories, bottlenecks in European gas deliveries, outages in Norway refineries, insufficient wind that reduced wind energy contributions, all set the stage for a perfect storm for natural gas. The surge in prices was amplified by speculation that, in case of a cold winter, tight physical markets could be in shortage. In China, coal prices have been rising and supplies are short, creating a power supply crunch, where 60 coal mines were forced to shut amid heavy rain, flooding, and landslides.
Finally, financial demand for oil assets is in full play: banks, which sold oil derivatives, are readjusting their hedges, systematic trend followers are adding positions, and demand for inflation protection is high.
On the supply side, conditions are also tight. In the US, shale producers remain focused on profitability imposed by shareholders, with output at around 85% of pre-covid levels. OPEC+ are keeping the high hand on the market and prices. They remain cautious in adding supply, and are likely to limit the pace of additions. Prospects of a nuclear deal with Iran remain distant, not boding well for a recovery in its crude exports.
As a result, oil physical markets will rebalance earlier than planned, propelling oil prices to a seven-year high.
How high are oil prices likely to go?
The tactical environment remains bullish for oil. Oil futures have returned in backwardation and a positive roll yield would attract extra flows (roll yield is the return from adjusting a futures position from one contract to a longer-dated contract. It is positive when a futures market is in backwardation, which occurs when the short-term contracts trade at a premium to longer-dated contracts). Risks remain on the upside.
Yet, we do not see oil prices returning to their last decade highs (around $100 per barrel), except in case of an abnormally cold winter. As we transition to a mid-cycle, moderating global economic growth and liquidity would cap demand and prices, not to mention that oil prices are likely to feel the brunt of the deceleration of the Chinese economy and of the Evergrande real-estate debacle, which will impact raw material demand. Demand elasticity to oil prices would also ultimately play out negatively. Furthermore, financial demand for oil assets (from banks, systematic models or for inflation hedging) will gradually lose traction, cutting some momentum forces.
However, balanced oil markets and the recovery in oil demand from Emerging economies next year (as vaccination and economic reopening gradually intensify) are likely to keep firm oil prices well into 2022. We see Brent trading modestly above $75 per barrel on average.
What would be the main consequences of a higher oil price regime?
Were oil prices to remain sustainably high, largest oil-importing countries and low-income populations would soon start feeling the heat, spurring social unrest in some countries (especially in Lebanon and Turkey). Power shortages in China would intensify, adding to supply-chain pressures for longer. Manufacturers would suffer margin erosion in a wide range of businesses from chemicals to auto makers. The erosion of consumers’ purchasing power would constrain the ongoing economic recovery.
Moreover, higher energy prices would spread to headline inflation, keeping markets and central banks on high alert. That said, the shock would remain manageable, given the declining contribution of energy prices to DM’s final inflation (from more than 10% in the US 10 years ago down to 7% today). Also, another inflation spike due to energy prices would largely be seen as transitory, keeping cool heads in central banks, which are much more focused on other stickier inflation contributors.
In DM countries, governments would likely seek to mitigate the impact for their population through subsidies or lower energy taxes, which would further deteriorate their fiscal balances. Protests in Europe against broadening plans to tighten emissions, feared to weigh the most on low income households, could lead to social unrest. It would also drive authorities in several European countries to consider or reconsider investment in civil nuclear capacities, as well as in Japan.
The latest IEA energy outlook emphasized that a net-zero emissions ambition for by 2050 is unlikely to be met, even if government fully complied with their commitments. While this will put pressure on authorities to speed up the energy transition, the ongoing energy crisis and new investments needed in oil and gas projects to ease its impact will be a stone in their shoe.
Conversely, largest oil exporters will enjoy increased revenues, including Mexico, Brazil, and Russia despite growing suspicions of manipulation. The energy crisis is helping Russia remind Europe that high natural gas prices can impact governments’ popularity. Besides, some OPEC members could be tempted to slow their efforts to reduce their dependency on oil revenues. US pressures on Saudi Arabia to add extra output could also strain their relationship.