What impact do oil prices have on the economy?

Oil prices are crucial in global markets for several reasons. The impact of oil prices is far reaching, affecting consumer spending, business costs, inflation, trade balances, and overall economic growth. When oil prices rise, consumers spend more on fuel, leaving less for other goods and services, while businesses face higher transportation and production costs, leading to increased prices and inflation. Central banks may raise interest rates to control inflation, potentially slowing economic growth. With higher oil prices, oil-importing countries experience wider trade deficits (i.e. when a country imports more goods and services than it exports), whereas oil-exporting nations benefit from higher revenues. There are multiple factors that can influence the supply and demand of oil, which in turn impacts its price and availability. These factors interact in complex ways, making oil prices highly volatile and sensitive to a wide range of influences. We summarise these demand and supply side factors below:

Factors Affecting Oil Supply

·       Production Levels: The volume of oil extracted by leading producers like the US, Saudi Arabia, and Russia greatly influences overall supply. Higher production leads to more supply, and lower prices

·       Oil Reserves: The size of oil reserves dictates the potential for extraction and market supply. Higher oil reserves indicates more supply and lower prices

·       Geopolitical Events: Political instability, conflicts, and decisions by organizations such as OPEC (Organisation of the Petroleum Exporting Countries) can disrupt oil supply leading prices to spike

·       Technological Advances: Innovations in extraction methods, such as hydraulic fracturing (fracking), can enhance supply levels, potentially lowering prices

·       Natural Disasters: Events like hurricanes can damage infrastructure, leading to temporary reductions in supply and therefore increasing prices

Factors Affecting Oil Demand

·       Economic Growth: Increased economic activity boosts the need for energy (including oil), across transportation, manufacturing, and other sectors, therefore increasing oil prices

·       Seasonal Variations: Oil demand can vary with the seasons, for example, higher need for heating oil during the winter

·       Substitute Goods: The rise of alternative energy sources like solar, wind, and electric vehicles can lower oil demand, potentially lowering prices

·       Government Policies: Regulations and policies that encourage energy efficiency and the use of renewable energy can influence demand levels

·       Consumer Behaviour: Shifts in consumer preferences, such as a move towards fuel-efficient vehicles, can impact the demand for oil, potentially lowering prices

Over the past decade, the oil market has experienced significant fluctuations due to various economic, geopolitical, and technological factors. Key events include the sharp decline in oil prices from 2014 to early 2016, driven by increased US shale production and OPEC’s decision not to cut output. Recovery began in 2017 with production cuts, stabilising prices around $70-$80 per barrel by 2018. The COVID-19 pandemic in early 2020 caused a dramatic drop in demand as a result of global lockdowns and reduced travel. Prices surged again in 2021 due to rapid demand recovery and supply constraints, reaching over $130 per barrel in 2022 following Russia’s invasion of Ukraine. Recent years have seen prices fluctuate between $70-$90 per barrel, reflecting ongoing adjustments in supply and demand dynamics.

Portfolio implications

These trends highlight the oil market’s sensitivity to geopolitical events, economic conditions, and technological advancements, all of which can influence portfolio returns. Oil is a physical commodity which can involve high costs and is highly volatile in nature (see chart below). This emphasises the importance of careful risk management when implementing in portfolios. There are alternative asset classes which can help access similar return drivers but with less volatility, this includes exposure to energy stocks, more general commodity exposure and downside risk hedging. Skilled active managers can also be employed to help access a broad basket of commodities (including oil) and they can adjust the allocations based on the attractiveness of each commodity. Investors should aim to incorporate diversification by sectors (e.g. healthcare), asset classes (e.g. bonds) and geography for genuine diversification in order to achieve better long-term performance. This is crucial for building a robust portfolio that can navigate various economic environments as seen over the last decade.

Source: FactSet

The Noise

• The European Central Bank lowered its deposit rate by 25 basis points this week to 3.5%, its second such cut since June following two years of aggressive rate hikes. The move had been clearly signalled, with investor attention already turned to what comes next and how ECB rate decisions will be shaped by what the Federal Reserve decide to do. ECB president Christine Lagarde commented that “our path, of which the direction is pretty obvious – a declining path – is not predetermined, neither in terms of sequence nor in terms of volume”. It seems unlikely that we’ll see a further rate cut at the ECB’s next meeting in October barring a major deterioration in economic conditions. However, a quarterly pace for cuts is likely to be the way forward, as inflation slows and growth in the eurozone falters.

• US inflation rose 2.5% in the 12 months to end of August, up 0.2% month-on-month from July. This marked the fifth straight month the annual measure has eased, having been dragged down by cheaper petrol prices. Underlying inflation, as measured by core CPI – which excludes food and energy costs - increased 0.3% from July and 3.2% from a year ago. This was an unexpected pick up, showing some stickiness amid higher costs for housing and travel. While this week’s inflation data won’t deter the Federal Reserve from cutting interest rates next week, it reduces the chance of an outsize reduction. Some investors were hoping for a 50-basis-point cut, though will likely have to settle for a standard 25-basis-point trim to interest rates.

• Previously shunned by asset managers, nuclear energy is set to make a comeback in sustainable funds. Nuclear had previously been an area out-off-bounds for investors with environmental mandates, but some fund managers think it’s clear that nuclear is an indispensable part of eliminating greenhouse gas emissions. The addition of nuclear to portfolios marketed as environmentally friendly is sure to fuel debate. Sceptics will point to concerns around nuclear waste and the supply of uranium, while proponents may argue that running a nuclear power reactor is emissions free. With the “AI revolution” likely to drive energy demand though the coming decade, it’s unlikely that the world will have enough energy to support this without the use of nuclear power.

The Numbers

The Nuance

As we look ahead to next week’s interest rate decision for the Bank of England, three key data points will help guide expectations of what is to come. Tuesday’s pay growth and unemployment data, and Wednesday’s GDP data will have been closely studied by the Monetary Policy Committee, as the last pieces of data released prior to their meeting.

Looking at British pay growth first, it cooled in the three months to July to a more than two-year low, with average weekly earnings excluding bonuses 5.1% higher than a year earlier. Despite new finance minister Rachel Reeves approving pay rises of at least 5% for millions of public sector workers, it is clear we are seeing a structural slowdown in pay. This should give confidence to the BoE when considering when to implement future interest rate cuts.

Turning to the unemployment rate, it fell slightly to 4.1% in the three months to July, from 4.2% in the three months to June. The data also indicated progress in reducing the number of economically inactive people of working age, a key priority for the new Labour government.

UK gross domestic product was unchanged in July, stagnating for a second month as economists had forecast a 0.2% increase. The UK economy has now failed to grow in three of the past four months, suggesting that a rapid recovery from recession is now losing momentum.

Overall, these figures are unlikely to sway the Bank of England to cut interest rates in September. Currently, investors have assigned a ~25% chance of a cut next week, which is only slightly higher than at the start of the week. For the rest of the year, investors expect the Bank of England to cut rates just once more.