Global equity markets gave back some of their year-to-date gains so far in September, while government bond yields moved noticeably higher. The market action can be attributed to mixed economic signals and messaging from central banks. On the latter, the Bank of Canada and U.S. Federal Reserve both decided to hold rates steady at recent policy meetings, while the European Central Bank raised its policy rate. All three central banks emphasized the need to tread carefully as they ensure that interest rates stay high enough for long enough to stem inflationary pressures. Recent inflation readings in Canada and the U.S. suggest that pricing pressures have begun to perk up, driven in part by oil prices. We discuss oil in more detail below.
Crude oil and refined products like gasoline, diesel and jet fuel have been on a sharp upward trajectory since June and are trading near their highs for the year. Global demand and supply have both been responsible for the price increases in recent months.
Demand in North America has been stronger than expected, driven by resilient economies, particularly in the U.S. where the summer travel season was notably strong. Demand in other parts of the world, such as Latin America and Africa, has also been stronger than expected. While China’s economic recovery following its reopening earlier this year has underwhelmed, its crude oil imports through the first half of the year have set a record pace, with much of the oil being deployed into the country’s inventories for future use. The International Energy Agency (IEA) estimates that roughly 75% of the increase in world energy demand this year will be driven by China.
The supply side of the equation has been as impactful. Over the past month, Saudi Arabia and Russia – the world’s biggest crude oil exporters and second and third largest producers, respectively – said they would extend their production cuts to the end of the year. Most market participants see this as a resolve to maintain higher oil prices, while Saudi Arabia has countered that sustainability of global demand is uncertain, and the country is merely tempering production to avoid oversupply.
Historically, the supply and demand imbalances that have created elevated oil prices often resolved themselves over time. Demand has typically deteriorated when prices are elevated, as consumers look to moderate the impact of higher costs. Oil producers have predictably raised production at more profitable price levels in the past, leading to increased global supply. Lower demand, increased supply, or a combination of both have ultimately driven prices lower in prior periods.
We expect global oil demand to moderate over time, as higher prices and slowing economic activity eventually take their toll. We have less conviction on the supply side, where there has been a notable shift in recent years with oil companies demonstrating more discipline and patience. Companies have been less willing to raise production at higher prices and have clearly prioritized profitability over revenue growth. In addition, major producers like Saudi Arabia and Russia appear to be intent on maintaining elevated prices for the foreseeable future, although predictions of their approach from one year to the next have been fraught with challenges.
High oil prices support inflation, which had been on a downward trajectory for most of the year until recently. This presents another challenge for central banks, who remain steadfast in their focus on ensuring that inflation can move lower and get back to their long-term targets. We expect that global markets will remain hyper focused on inflation for the remainder of this year.
If you have any questions, please do not hesitate to contact us.
Drew M. Pallett LL.B. CFP
Senior Portfolio Manager and Investment Advisor
RBC Dominion Securities
Email: drew.pallett@rbc.com