Inflation and Oil: Not Always a Slippery Slope

Last week West Texas Intermediate (WTI) oil prices rose to $63 per barrel, up from $27 in early 2016. Rising oil prices can be inflationary and in extreme cases, like the 1973 and 1979 oil shocks, rapidly rising oil prices can lead to recessions and inflation. Those who remember shortages and gas lines know it’s no fun pushing a large Chevy Impala after the gas tank runs dry!

But this time rising oil prices are not a slippery slope to inflation.

Oil prices are rising now from very low levels as record inventories are finally coming back into balance (see chart below). As you remember, back in 2013 and 2014 inventories were low, prices were above $100 barrel and OPEC decided to flood the oil market to put the U.S. shale oil industry out of business. When that didn’t work, OPEC and other oil producing nations reduced production, and inventories slowly came back into balance. Better to earn more dollars on less production than to go bankrupt pumping lots of oil! To be fair, today’s rising prices are not just a function of lower inventories, but also a function of strong energy demand and higher global tensions.

So why won’t inventories continue to fall and prices rise?

As we get to the sweet spot of $60-70 a barrel for WTI, U.S. shale oil becomes more competitive and production rises. Shale production is a game changer in the oil industry. It used to take a decade or more to find and develop large conventional oil fields, like Prudhoe Bay in Alaska, where a long and lumpy supply response contributed to boom and bust price cycles. But shale production can come on line in a matter of months, not years or decades. This rapid supply function should help moderate the boom and bust cycle. The EIA (U.S. Energy Information Administration) notes U.S. crude oil production averaged 9.3 million barrels per day (b/d) in 2017 and production is forecast to average 10.3 million b/d in 2018, which would mark the highest annual average production in U.S. history , surpassing the previous record set in 1970. The EIA forecasts production to increase to an average of 10.8 million b/d in 2019. On top of increased U.S. production, Saudi Arabia and Russia are running large budget deficits and will want to raise their production as soon as they can do so without ballooning inventories and crushing prices.

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The risk of a sharp rise in oil prices contributing to inflation is reduced due to U.S. shale becoming the oil industry swing producer. But despite this reduced risk, we still need to worry (sometimes a lot) about military conflicts cutting off supplies and pushing up prices – oil will always be a little slippery!

Source: U.S. Energy Information Administration, The Financial Times, Bloomberg