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Are we heading for higher oil prices?

This week saw OPEC, the oil cartel whose members account for around 40% of global supply, confound sceptics by finally reaching an agreement for a modest cut in production for the first time in eight years.

Jason Hollands Jason Hollands
30 September 2016

This has the potential to bring a prolonged phase of aggressive oversupply to an end – driven principally by Saudi determination to see off the threat posed by the US shale industry, but which has been further complicated by the lifting of sanctions on its arch-foe Iran following its accord over its nuclear ambitions. In the Middle East, oil supply is equivalent to gunboat diplomacy and a weapon of political influence.

The OPEC announcement, which has allowed Iran to be exempted from a production cap as it rebuilds its market share, was greeted by an immediate sharp hike of 5.3% in oil futures on the New York exchange. This should prove positive for the UK stock market, which has significant exposure to the oil and gas sectors, with shares in BP and Royal Dutch Shell rising sharply in trading following the news. There are of course two sides to the story – casualties on the back of the news were airline stocks such as Easyjet and International Consolidated Airlines, which both saw their share prices dip.

 

Will the deal stick?

The key question is whether or not the deal will stick. Cartels are notoriously instable and decisions over who will cut production and by what amount have been parked until November. In itself the proposed production cut broadly offsets recent increases in output from the likes of Iran, Russia, Libya and Nigeria. And a further uncertainty is how non-OPEC members might choose to respond, as we may see US producers crank up their output.

 

Will inflation be affected?

Alongside anaemic global growth and manufacturing overcapacity emanating from China, low oil prices have been a major factor behind very low levels of inflation across the globe. If the deal to reduce oil output holds and demand/supply continues to rebalance, it follows that this could feed through to higher inflation including rising prices at the petrol pumps.

 

Good news for the US, but what about Europe?

Sustained higher oil prices would also be good news for the US, easing pressure on the shale oil industry, which has experienced a wave of bankruptcies. This should benefit the US high yield bond market which has significant exposure to oil-related credits.

However, for regions that are major net importers of oil, such as Europe, Japan and India, a sustained move to higher energy prices will be less welcome. This will reduce what has in effect been an added form of stimulus, placing greater cash in the hands of consumers.

Though, given the modest nature of the proposed cut in production and the potential for non-OPEC members to increase supply, it would be premature to anticipate oil prices rising to anything like the levels seen a couple of years ago.

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