Oil prices have been on a wild ride the past few years. In April 2020, near the beginning of COVID lockdowns, West Texas Intermediate (WTI) crude oil briefly traded below negative $USD 35 per barrel, as storage costs soared amidst cratering demand. Two years later, the outbreak of war in Ukraine propelled prices to levels not seen since oil’s all-time peak prior to the Lehman Brothers collapse in 2008. The period since has seen prices cool off as central bank monetary tightening has weighed on oil consumption expectations and Russian exports have been surprisingly resilient. With OPEC+ recently announcing meaningful supply cuts, a review of oil market dynamics and the corresponding implications is warranted. 

Per the chart below, oil price spikes reliably lead broad inflation. Currently, energy only carries a roughly 7% weight in the US consumer price index (CPI) but punches well above its weight. This is due in large part because most other CPI categories require significant energy inputs for production, transportation and operation. The WTI price spike that ensued following the Russian invasion last year helped ignite inflationary pressure, which had already been gathering pace as lockdowns ended, while supply chain issues persisted. Conversely, the lull in the period since has had an outsized influence in helping inflation roll over. Accordingly, one of the key economic and financial risks is that renewed strength in oil prices keeps inflation elevated and forces central banks to stay hawkish for longer.   

An extensive (and ever-shifting) list of factors influence oil prices and the interplay between oil supply and demand. As with most multi-faceted analyses, some critical variables point in different directions. From an oil demand perspective, these differences are particularly stark. At the top of the list is the somewhat unusual divergence between the trajectories of the world’s two largest economies (and the impact on their respective energy consumption); a by-product of differing COVID public health measure approaches. While the US economy has been impressively resilient of late, the Federal Reserve’s tightening campaign will increasingly bite into household and business demand. The Chinese economy has a completely different set of circumstances, with loose monetary policy conditions and the release of pent-up demand from recently ended lockdown restrictions.

The supply side of the equation carries its own crosscurrents, but we believe is tilted in favour of higher prices. The combination of OPEC+ production cuts, energy majors electing to return cash flow to shareholders instead of drilling wells and the eventual replenishment of the US Strategic Petroleum Reserve are all supportive factors. While Russian oil exports have surprised on the upside, lost access to Western machinery and technology creates production risks. A wildcard scenario which would be negative for prices would be the signing of a new Iran nuclear deal.

Lastly, the US dollar may come under continued pressure as interest rate differentials move from being a tailwind to a headwind. Oil (and most commodities for that matter) is priced and traded primarily in US dollars; and tends to have a negative correlation with the greenback. 

Patching together the myriad of factors, we expect the path of least resistance for oil prices to be upwards. The good news (from an inflation-fighting perspective) is that absent any major surprises, this would likely be a gradual drift higher in prices, rather than a renewed surge. Inflation is likely to remain stubbornly elevated (sorry central bankers), but we do not expect a renewed acceleration from current levels. We have kept equity and fixed income duration short in order to avoid the more vulnerable interest rate sensitive segments of the market, while overweighting commodity-related exposures which offer an attractive hedge against inflation.