Oil prices have been rising, reaching as high as $80/bbl (Brent), more than $30/bbl higher than in mid-2017. We want to focus here on why oil prices have increased more than expected; whether we think the recent increase is sustainable; and what the effects on the U.S. economy and monetary policy might be. As always, our views on developments in the oil industry are informed by our ongoing discussions with Larry Goldstein.
The Sharp Rise in Oil Prices This Year: It’s About Fundamentals
The sharp rise in oil prices this year appears to be primarily about stronger-than-expected demand. While individual members of OPEC have faced supply disruptions, aggregate OPEC production has essentially followed the agreed-upon limits. U.S. production has been stronger than anticipated a year ago. So we can rule out weaker-than-expected supply as an explanation for the higher prices. Even as supply has held up, however, inventories have been drawn down more than expected.1 That drawdown, even as supply has held up, points to the culprit: stronger-than-expected global demand. Certainly, geopolitical risks have become more prominent recently and are playing a role in oil prices as well. This is reflected, for example, in the unusually large premium for Brent relative to WTI.2 But the demand story dominates when it comes to explaining the sustained run-up in prices over a longer period.
Is Today’s Price Sustainable?
We expect oil prices to moderate from their recent highs, but only somewhat. We believe that prices in the range of $65-$70/bbl (WTI) are sustainable, higher than our previous assumption of around $60/bbl, with prices ending this year near the upper end of that range and then moderating toward the lower end in 2019 and 2020. Contributing to the stronger outlook for prices are the economic/political issues in Venezuela, where we expect future production to decline by half a million barrels per day, and the modest but real negative impact on Iranian production due to new U.S. sanctions. If stocks had been as high as markets had initially projected, these factors would have been ignored by the markets. But with stocks tight, they can’t be ignored.
There had been some buzz that the Saudis wanted oil prices in the $80-$100/bbl range. But we didn’t think the Saudis would support substantially higher prices, because they don’t want to bail out Russia and Iran. Indeed, this view is consistent with the recent news that Russia and Saudi Arabia are close to finalizing a deal to increase production in response to the rise in prices. In any case, OPEC has not been a factor pushing up oil prices over the last year. They have done what they said they would do: Hold production steady.
1 U.S. inventories are even tighter than they might appear to be relative to levels in previous years, considering that more of those stocks are unavailable because of the expansion of U.S. infrastructure.
2 U.S. crude exports have risen to record levels, benefiting from this differential, but can’t do much more because of infrastructure constraints.
Enter the IMO
The IMO (International Maritime Organization) is a U.N. body that regulates shipping. They have set a rule to be implemented on January 1, 2020, that would require fuel oil used on board ships to have a sulfur content below 0.5%, significantly lower than the current limit of 3.5%. Ships can achieve this by using lower-sulfur fuel or by installing scrubbers. But there are not nearly enough scrubbers, so this rule would significantly increase demand for components of light, low-sulfur products such as diesel, which has a sulfur content of just 0.1%. This would boost prices of light products significantly, perhaps $10-$15/bbl. It would also boost crude prices, but to a somewhat lesser extent, perhaps $5-$8/bbl. The $65-$70/bbl range we assume excludes the impact of this regulation.3
Higher Oil Prices and Aggregate Demand in the U.S.
In our last forecast, we assumed oil prices would be $60/bbl (WTI) in 2019 and 2020, and we now expect prices to be $5-$10/bbl higher over that period. Higher oil prices reduce real disposable income and household spending. This adverse effect on real GDP is, in principle, partially offset to the extent higher prices lead to increased investment related to energy extraction. We don’t expect the higher path of oil prices to have a substantial impact on real GDP growth or monetary policy. Simulations of a $10/bbl increase in oil prices through 2020 using FRB-US suggest a small impact on the level of real GDP, about a tenth of a percent, and a negligible impact on the unemployment rate. Such a “shock” would not even warrant attention from the FOMC.
In addition, FRB-US does not incorporate the positive effect of higher oil prices on investment related to energy extraction. In principle, even that modest effect on consumer spending should be partially offset by an increase in investment as producers respond to the higher oil prices. However, we suspect that there may be a more limited supply response than we saw previously when oil prices declined sharply. Production from fracking has already increased a lot from improvements in technology that yield more barrels per drilling rig. Indeed, the added supply has caused a problem for producers because the infrastructure has not kept up with production. Pipelines are at capacity, so producers must sell oil at a discount to compensate for the higher transportation costs of trucking, which adds more than $10/bbl.