Will higher oil prices hinder central banks’ inflation progress?

October 05, 2023 | Frédérique Carrier


Share

We explore the reasons for the price surge and how to position portfolios.

Strong supply and demand dynamics

Despite recent weakness, oil prices are up by some 20 percent since the end of June. Brent Crude surpassed the $95 per barrel (/bbl) mark in late September.

The Saudi Arabia and Russia oil production cuts are the most popular explanation for the price surge. On Sept. 5, these two OPEC+ leaders announced they would extend supply curbs of approximately 1 million barrels per day (bbl/d) and 300,000 bbl/d, respectively, until year end. The cuts had been expected, though the duration took market participants by surprise.

But there are other reasons behind the recent oil price move. U.S. economic resilience has also enabled demand to remain strong. RBC Capital Markets, LLC’s Global Energy and Digital Intelligence Strategist Michael Tran argues that U.S. consumer demand has remained robust so far despite “U.S. pump prices clocking in at a notional all-time high on a seasonally adjusted basis.” His assertion is based on his team’s tracking of daily visits across more than 135,000 U.S. gas stations. That data, which is then compiled and studied on a weekly basis, is presented in RBC Capital Markets’ Digital Intelligence Strategy report.

Tran also points out that U.S. consumers spend only 2.3 percent of total Personal Consumption Expenditures (PCE) on gasoline, compared to 3.2 percent historically using an inflation-adjusted retail price dating back to 2000. In his view, consumers feeling the pinch of higher oil prices are more likely to trim spending on other items before they reduce spending on the essential good that is gasoline given it represents a smaller portion of consumers’ expenditures than usual.

Demand elsewhere has also surprised to the upside. China’s demand for oil continues to strengthen, despite the evident economic slowdown. According to Tran, China crude imports set a record pace of 11.4 million bbl/d through H1 2023, registering three of the four strongest crude import months on record. He believes that energy security remains central to Chinese policy and that the country will look to rebuild product inventories heading into the winter. We believe material economic deterioration is a risk to that scenario.

Global oil demand for top three oil-consuming countries
Thousands of barrels per day
Country 2023 2024
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
U.S. 20,387 21,095 20,901 20,494 20,197 20,774 20,838 20,280
China 15,185 15,922 15,751 16,117 16,160 16,522 16,580 17,047
India 5,566 5,519 5,168 5,633 5,651 5,712 5,376 5,903

Source - RBC Capital Markets, RBC Wealth Management

Overall, such developments on the demand side as well as demand strength from non-traditional consuming regions such as Latin America and former Soviet Union states largely explain why the International Energy Agency, a global agency, has revised global oil demand higher by 780,000 bbl/d since the start of the year.

With supply cuts and firm demand, Tran characterizes the physical oil market as being “the strongest in 12 months,” and he sees West Texas Intermediate (WTI) and Brent prices remaining elevated. But with “acute upside catalysts not entirely visible,” he forecasts oil prices to remain close to current levels, averaging $86.50/bbl and $91.00/bbl in Q4 2023 and in 2024, respectively. This compares to the current $84.40 and $85.95, respectively.

Oil price forecasts
  Q4 2023 Full-year average
2023 2024
WTI (spot/bbl) $86.50 $79.25 $86.50
Brent (spot/bbl) $91.00 $84.00 $90.00

Note: Q4 2023 forecasts are an average in the quarter.

Source - RBC Capital Markets

Higher oil prices’ impact on inflation

Many investors worry the surge in oil price means inflation may prove more difficult to tame and could even derail central banks’ fight against it.

We think it is a reasonable concern as the ongoing move up in oil prices suggests to us disappointing inflation results over the next few months.

However, central banks typically have focused on measures of core inflation, which excludes food and oil prices. That is because central banks recognize they can’t do much to influence them. Oil prices are also particularly volatile and, therefore, an unreliable target for policymakers.

On that front, the progression of core inflation is largely satisfactory in the U.S., as it dropped to 4.3 percent in August. More concerning for the Fed might be the United Auto Workers and Kaiser Permanente healthcare workers strikes and their potential effect on wage growth should the strikes encourage employees in other sectors to up their own wage demands.

Absent such pressures, RBC Global Asset Management Chief Economist Eric Lascelles thinks the broader inflation backdrop should resume its improvement when energy prices stabilize. He believes that the U.S. government’s efforts to lower healthcare costs by targeting 10 popular drugs for aggressive price negotiations may contribute to the lowering of inflation over the long term.

For now, we think the Fed has reached the end of its rate hike cycle, although one more increase may be possible before year end, depending on the progress of inflation.

In Europe, higher oil prices are occurring against a backdrop of weakening demand. Beyond resulting in slower progression of inflation towards the two percent target, higher oil prices could crimp consumer and business confidence and spending, which are already suffering. This would reinforce the current disinflationary trend, which is being caused by weaker demand.

Yet, the European Central Bank will be very keen to monitor whether high oil prices lead to a de-anchoring of inflation expectations. With the bank recently stressing that not being forceful enough with rate hikes is more costly to the economy than being overly aggressive, it may decide an additional rate increase is needed and keep interest rates at that new level for longer.

Energy stocks respond to higher oil prices

For now, the most direct impact of higher oil prices has been on the Energy sector which has rallied close to 20 percent in U.S. dollar terms since June. RBC Brewin Dolphin Head of Asset Allocation Paul Danis explains that energy stock valuations are pricing in a weak secular growth environment as the energy transition progresses. Even after the recent rally, the global sector currently trades at a discount to the broad market of 38 percent on a forward price-to-earnings basis. Global energy has a 4.2 percent dividend yield as of this writing, well above the current 2.6 percent yield of the MSCI All Country World Index. Energy stocks can act as a good portfolio hedge should oil prices resume their ascent.

However, investors should be mindful that Energy is a low-growth and, therefore, “low-duration” sector. Danis believes, therefore, that all else being equal, the sector should do relatively well when central bank interest rates rise, and vice versa. The rise in bond yields over the past three years has thus been supportive of the Energy sector outperformance. However, if, as we suspect, we are close to the peak in bond yields, a decline could well remove a performance tailwind. We view a position in energy stocks around market weight as appropriate as we believe return of capital to shareholders through dividends and share repurchases should continue in the years to come.