Oil prices and an economic overview from Bill Greiner.
Jun. 7, 2018 Commentary

Oil Prices And Economic Growth

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One of the more enjoyable aspects of my job is interacting with clients who I consider among my friends. I recently made a few presentations in Arkansas, Missouri and Oklahoma. During these presentations, the consistent questions centered on the economic implications of the current events in Washington. The other constant was a desire to discuss the price of oil and the rise in pricing we’ve witnessed over the last year.

Oil prices have risen rapidly, especially since the first of the year. Recently, though, oil prices have declined as the Saudis and Russians may be willing to start the process of increasing output. We will see how this works out. Nonetheless, oil prices have still risen rather dramatically over the last year, even with the recent events. Since the first of the year, oil prices (West Texas Intermediate) have risen by 24.4 percent and by 39.1 percent year-over-year as of May 21, 2017.

These price increases are meaningful given the fact that overall inflation has been rising at a 2 percent average over most of the previous 12 months. While general prices have been rising, oil and gasoline prices have been sprinting ahead. What probable economic impact could investors and consumers anticipate from the rapid increase in oil and gasoline prices?

Supply and Demand 

Let’s take a peek at our old friends, supply and demand. In the case of oil prices, pure supply/demand analysis may be a good starting point; however, political influences have always had a hand in market petroleum pricing. But, we need to understand the basics of supply and demand to understand the potential economic impact of rising oil prices going forward.

Demand

  • Global demand for oil rises and falls with overall economic growth. Currently, the International Energy Agency (IEA) estimates global oil demand of 96.2 million barrels per day. They also suggest demand in 2018 will grow by an average of about 1.4 million barrels per day, or an increase of about 1.5 percent. This compares to the International Monetary Fund (IMF) expectation of 4 percent overall economic growth in 2018.
  • The IEA estimate was recently cut from an expected growth rate of 1.7 percent for 2018 due to rising oil prices, which obviously puts a lid on overall demand growth for the commodity. 
  • So, while an increase in demand for oil is occurring, the growth level in demand isn’t high enough to spur an upward move of 24 percent in oil prices so far this year.

Supply

  • This is where the interesting developments in the world are affecting pricing. Global oil inventories as a percent of daily demand have fallen dramatically over the last year.
    • In the United States, current oil inventories total 25.6 days of demand. According to Ned Davis Research (NDR), this is down from a high of 37 days in early 2017. What this means is there is less oil “on hand” in the marketplace now, as compared to a year or so ago.  
    • This reduction in oil inventories, which has been a prime reason behind the rise in oil prices over the last year, has been driven by events and decisions occurring in three major areas of oil production.
      • Until recently, the Saudis and Russians agreed to cut production levels. This agreement has been in existence since early 2017.
      • Until recently, Iran was forced to reduce oil output.
      • Oil production in Venezuela has dropped to 1.4 million barrels per day, the lowest level of oil production from this country in 30 years, according to the Kallanish Energy Report. Due to the political and economic crisis in this country, oil production has declined by almost 30 percent in the last 12 months. 

The reduction in oil output from Russia, Saudi Arabia, Iran and Venezuela has been enough (in combination with a rise in global oil demand) to push prices upwards as noted earlier.

Economic Impact of Rising Oil Prices 

Now that we understand the basics of the supply and demand picture for oil, what kind of economic impact should we expect going forward to the current rise in oil and gasoline prices?

  • Probable Economic Growth. According to NDR, historically a 10 percent price increase in oil has led to 0.2 percent lower overall gross domestic product (GDP) growth a year later. Given the fact that oil prices have risen by 39 percent over the last year, one may expect the impact on economic growth to be rather substantial. However, oil imports have been reduced by almost 50 percent in recent years. This should reduce the negative macro-economic impact of rising oil prices.
  • Macro-Economic Impact Muted. Oil production in the United States is now at 9.8 million barrels per day, the highest level of production in more than 45 years. Additionally, oil production and mining operations are now employing an additional 98,000 workers than was the case four years ago. On balance, these are well-paying jobs; workers in the oil fields make about 20 percent more than the average worker in the United States. Lastly, drilling activity occurs as oil prices rise. Drilling an oil well is a very capital-intensive activity. According to NDR, the oil price a company needs to profitably drill a well in the United States is now at $52 per barrel. Currently oil prices are at $62 per barrel. Expect to see additional oil drilling to occur going forward.  
  • Economic Impact on Consumers of Rising Oil Prices. I filled my gas tank today and paid $3.49 per gallon (premium in Arizona). It cost me $73.50 to fill my SUV tank. Historically, for every 10 percent increase in oil prices, consumer activity tends to be negatively impacted by .2 percent a year later, according to NDR. For most consumers, spending on gasoline tends to occur, irrespective of costs. If oil prices remain elevated, expect to see an eventual impact on consumer discretionary spending patterns.
  • Impact on Inflation Trends. Again, according to our friends at NDR, the impact of rising oil and gasoline prices on inflation has become muted as compared to historical trends. The correlation of rising oil prices and inflation was very high from 1973 – 2000. Over that period of time, oil prices and inflation rose lockstep at a 70 percent rate (correlation coefficient). Since that time, the trends, while positive, have become muted. From 2000 – 2018, the correlation of oil price changes and inflation has been about 20 percent. So, while rising oil and gasoline prices have an impact on overall inflation, the trends have become much more muted than was the case in the past.

What is our bottom line on the economic impact of rising oil prices? Consumption activity should slow somewhat, but capital expenditures should rise nicely. Overall, the United States is still an energy importer, albeit at a 50 percent lesser rate than has been the case in the past. We suggest that, unless oil prices rise well above $80 per barrel, the overall impact on economic growth should be manageable.

 

The views expressed in this article are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or as a solicitation to buy or sell any security or engage in a particular investment strategy. Please consult a financial services professional.

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