Massive excess supply pushing oil prices down.

Energy , which accounts for almost 10% of the Irish CPI and  a slightly higher share of the equivalent EA index, tends to be the most volatile inflation component. This reflects the nature of crude oil  demand , which is very unresponsive to price in the short run and so small changes in supply can have a large impact , although the full  knock-on effect on the market price of fuel is diluted somewhat by the incidence of tax, which is high in many European countries, including Ireland. This works to dampen the effect of a sharp rise in crude prices and to reduce the gain to consumers following a large fall, although the impact on the CPI can still be significant if the move in crude prices is large enough.

That has certainly been the case in 2015; Irish energy prices in July were 6.7% lower than  the previous year with a similar  fall across the EA, helping to reduce overall inflation rates. For example, the annual  EA inflation rate in August was just 0.2% instead of 1.1% if one excludes the energy impact.

The consensus view, and one shared by the ECB, envisaged inflation picking up in the latter months of 2015 as the impact of weaker  energy prices dropped out of the annual inflation rate but that now looks less likely following renewed falls in energy and other commodity prices; the price of Brent crude had appeared to be stabilising  at over $60 a barrel in the early summer but started to slide in July, with the decline gaining momentum through most of August, to a low of under $43 at one point, levels last seen during the global financial crash in late 2008. Brent has recovered a little ground of late but that plunge, which was even sharper in euro terms, should translate in to another round of lower fuel prices and hence overall inflation rates- our  own Irish Petrol Price Indicator points to €1.31 a litre from around €1.43 a month ago.

What has precipitated such a slide in the price of crude?  Global economic activity is less energy intensive than it was but the International Energy Agency (IEA) still envisages world oil demand rising by 1.6 million barrels per day (mbd) in 2015, a significant pick up from the 2014 outturn. Weaker than expected growth in China could reduce that estimate but it seems clear that demand is not the main issue. Supply  would therefore  seem to be the driver  of the price collapse, and that is indeed the case, with some estimates putting the excess available in the market in q2 at some 3mbd, an extraordinary figure by historical standards,  and  helping to push OECD oil inventories to record levels.

One factor at work is the continuing rise in non-OPEC supply, which is put at around 1.3mbd in 2015, largely reflecting higher US output, including that from shale. Iraqi supply has also risen substantially over the past year (to record levels) and one might expect Saudi Arabia, the traditional swing producer in OPEC, to reduce production and hence supply from the cartel in order to support price. That has not happened , implying the Kingdom  is adopting a new strategy, perhaps with the aim of  impacting the future development  of non-OPEC supply, particularly from shale. Whatever the rationale the result is that  the world is awash with oil at the moment and few analysts envisage a  significant rise in prices over the next few years. Supply shocks are always possible, of course, which would change the outlook, but in the short term at least consumers are likely to receive another boost to purchasing power via lower fuel costs.

Published by

Dan McLaughlin

Economics Lecturer and Commentator