Interest rates set to rise significantly in the long term
Over the past few weeks and months, it has become apparent that, as tensions in the Middle East escalate, the price of oil – as well as many other markets – hardly reacts negatively to this at all.
The price of oil has fallen sharply since it appeared that Iran and the US were on the verge of reaching an agreement. Recently, however, it has become clear that the two sides are finding it far from easy to reach an agreement. In fact, hostilities have flared up again recently and Iran has once more closed the Strait of Hormuz.
You will no doubt recall the view expressed a few months ago – including by us – that, if free passage through the Strait of Hormuz were not restored quickly, a major oil shortage would arise and oil prices would consequently soar. On balance, however, little or no oil has been passing through the Strait for quite some time, whilst the price of oil has remained stuck at around its recent low. How is this possible?
Until recently, the following explanations were given:
- The reduction in oil supplies has largely been offset by drawing on reserves. In itself, this is correct, but at some point the reserves will run out. Experts had expected this to be the case by now, but that appears not to be the case. The remarkable thing is simply that markets look ahead. Normally, the price should already be rising if a shortage is expected in the foreseeable future.
- It is also sometimes argued that the market mechanism has simply done its job. When the war began, the price of oil shot up. This led to lower demand and greater supply, causing the price to fall sharply again. However, this reasoning is incorrect. If part of the supply is withdrawn, a new equilibrium price does indeed emerge, but at a higher level. That has not happened.
The market is looking ahead and anticipating a surplus of oil once the war in the Middle East is over. That may well be the most compelling explanation, but it fails to take into account the fact that nobody knows when oil supply will return to pre-war levels. Moreover, there will be additional demand for oil for the time being in order to replenish stocks.
Conclusion
As yet, no satisfactory explanation has been given for the fact that the oil prices have risen only slightly for some time now, even as tensions in the Middle East have flared up again. It is therefore likely that something else is going on.
The most plausible explanation is as follows.
Normally, the prices of petrol, diesel and other products made from oil move in line with the oil price to roughly the same extent. Recently, however, this has not been the case. Petrol and diesel are trading at price levels consistent with an oil price of around $100 or higher, rather than the current price of approximately $75.
The explanation for this is probably straightforward. Russia accounts for a large proportion of the world's refining capacity, and Ukraine has now taken more than 10 per cent of that out of action. Moreover, that percentage is rising rapidly. In addition, several refineries in the Middle East have also been severely damaged by Iran.
This has led to major shortages of petroleum products. As the damage inflicted cannot usually be repaired quickly, these refineries require ever-less crude oil. After all, their production capacity has been significantly reduced. The end result is a reduced supply of petroleum products, but at the same time a reduced demand for crude oil.
Implications for inflation (expectations)
Energy prices generally have a significant impact on inflation. It is not that energy accounts for a very large proportion of consumer expenditure, but it is mainly a matter of so-called secondary effects. In other words, the manufacture of many products often consumes a great deal of energy, which means that if oil prices rise, the cost price of many other products increases. This is then met with a rise in prices.
To assess this effect, one must look primarily at the prices of electricity, petrol, diesel and so on. Most people, however, take the easy way out by looking only at the price of oil. Normally, the prices of other products move almost in lockstep with the price of oil.
However, as we have already pointed out, the situation is now different. If one looks only at the price of oil, one is currently assuming far too small a price rise for all sorts of other energy products. This is a situation that we do not foresee changing for the time being. This therefore means that, when it comes to inflation forecasts relating to energy prices, there will soon be two setbacks:
- It is generally assumed that neither the US nor Iran has any interest in a protracted war and that a new peace agreement between the two will therefore be concluded shortly. In other words: the Strait of Hormuz will not remain closed for long.
We disagree with this view because – as we have indicated in our recent reports – Iran does indeed stand to gain from keeping the flames stoked for a while longer. In our opinion, completely unrestricted passage through the Strait of Hormuz is not on the cards for the time being.
- Ukraine will continue to bomb Russian refineries for the time being, and Iran may well do the same to its neighbours.
This means that, for the time being, we expect the spread between the prices of various energy products and the price of oil to widen rather than narrow.
Now, if we look at the US, the economy there is still growing at a reasonable pace. In particular, the boom in investment in AI is driving growth upwards, whilst interest rates are not high enough to significantly slow growth. In addition, high share prices are creating a positive 'wealth effect'.
Consequently, we expect the rise in the prices of various energy products – which is therefore much greater than that of crude oil – to lead to a number of secondary effects. In other words: in the US, we expect inflation trends to be disappointing in the coming quarters. However, this applies to a much lesser extent to Europe, as economic growth there is significantly lower.
