Stronger euro and weaker oil bad news for ECB hawks

Last December the euro briefly traded below 1.04 against the US dollar and few forecasters envisaged a short term recovery, with a number calling for parity against the greenback. In the event the euro has appreciated, with the past two months seeing a notable rally, taking the single currency above $1.12. The consensus has also shifted, with many abandoning bearish calls in favour of further euro appreciation. Speculative positioning  has also tilted decisively, with the market now running modestly long the euro/dollar for the first time in over three years.

One factor driving the euro is the economic data, which has generally surprised to the upside,  in turn prompting analysts to revise up their GDP projections. As a consequence many now expect the ECB to shift its policy stance, moving initially towards less dovish rhetoric before changing its forward guidance, although a rise in the deposit rate is not fully priced in until the latter part of 2018. In contrast, the US data has tended to surprise to the downside and the market, which was effectively pricing in two further rate hikes in the US this year, is now much less confident about the second ( although  a rise this month is still seen as highly likely)

In its  Staff forecast in March the ECB projected inflation at 1.7% in 2019, predicated on a euro/dollar rate of $1.07 over the forecast horizon. The exchange rate is seen to have a significant impact on prices in the EA and if the next forecast ( due later this week) used a rate of $1.12 that , all else equal, may push the inflation forecast for 2019 down by as much as 0.2 percentage points.

Moreover, the March forecast assumed an oil price around $56 over the next few years, and that now looks too high, given developments of late , with  Brent crude prices falling to around $50 on market concerns that the OPEC cuts have not been sufficient to make an appreciable dent in the unusually high level of crude stocks. Again, a lower oil price projection, say around $50, would shave up to another 0.2 percentage points off the inflation projection.

Of course the Staff may revise up some other components ( wage growth for example) to avoid having to lower the inflation outlook, and one sometimes wonders if the forecast drives ECB policy or the other way round, but on the face of it the combination of weaker oil and a stronger currency should have a disinflationary impact.

 

The Price of Oil

It is not that long ago that the price of crude oil approached $150  a barrel (a barrel of oil equates to around 35 imperial gallons) and  the airwaves  were full of discussions on  ‘peak oil’ and the possibility of $200 as a realistic price forecast. In the event prices collapsed in the wake of the financial crisis , declining to around €35, before recovering and stabilising at over $100 from 2011 to mid 2014. Prices then fell precipitously, to around $50, before rallying briefly in the early months of 2015  but then the slide resumed, with the downward momentum increasing in recent months, taking Brent crude,the European benchmark, below $30 for the first time in over a decade.

The demand for oil is very unresponsive to price changes in the short term (in economic terms the price elasticity is close to zero) so any change in supply will have a large impact on price, be it on the upside or the downside, but it is useful to distinguish some medium term factors affecting the market from some shorter term developments.

The demand for oil will rise with economic activity and so it is not surprising that global demand in 2015 , averaging 94.5 million barrels a day (mbd ) according to the IEA, is considerably higher than it was before the crash in 2007 (86.5mbd). What is surprising though is that demand in the developed world (OECD countries) is actually 3mbd lower now than it was  eight years ago, leaving emerging markets as the driver of the increase in world demand for crude, with China being particularly important (it now accounts for 12% of global oil demand from 8% in 2007).

There have also been some fundamental changes on the supply side of the market. Non-OPEC supply has risen by 7.5mbd since 2007, from 50.9mbd to 58.4mbd, driven by a surge in production from North America, where output has risen to 19,8mbd from 14.3mbd. Consequently , the implied call on OPEC supply has not greatly changed and the cartel’s market share has fallen. In the past Saudi Arabia has acted as ‘swing’ producer in OPEC, cutting output in order to stabiise prices at times of excess supply, but it changed policy in 2014, seeking to maintain market share, Iraq’s output has also risen substantially ,  and the resultant increase in OPEC output has contributed to persistent excess supply in the market; supply exceeded demand by  1mbd in 2014 and by a further 1.8mbd in 2015. Stocks have therefore risen sharply and the scale of the overhang has clearly put huge downward pressure on crude prices.

In terms of shorter term factors, global growth has consistently disappointed (the IMF has again reduced its  forecast for 2016) and China is slowing, so the market has scaled back estimates of oil demand growth for this year (the IEA expects 1.2mbd). Non-OPEC supply may actually fall a little but this is likely to be more than offset by higher Iranian output (now that sanctions have been lifted)and from other OPEC members, so the consensus is that excess supply will grow in 2016, albeit at a slower pace than of late. In addition, global demand fell unexpectedly in the final quarter of 2015, back to 95mbd from 95.5mbd, as a result of an  unusually mild early winter  in the Northern Hemisphere, but supply was broadly unchanged at 97mbd, exacerbating the excess supply issue.

The plunge in oil prices obviously benefits oil importers and  hurts oil producers so the global impact is difficult to disentangle. The IMF believes that the boost to real consumer incomes (via lower retail fuel prices) and the  reduction in  energy costs for firms offsets the  loss of spending power from oil producers and investment in oil production,; global growth may be boosted by over 1% as a result of the recent price falls, according to the Fund. Others disagree, arguing that the cut in investment spending in the US on oil production, for example, is offsetting the impact of lower fuel prices for consumers. The positive correlation between equity markets and the oil price of late implies investors believe the latter or see the price decline as demand driven rather than from the supply side, That does not fit the facts, however, and although it is anyone’s guess how low prices will go in the short term one doubts if the marginal cost of oil production is $30 or below so prices at that level or lower are not sustainable.

Euro and Oil price likely to prompt ECB action

The Euro Area has experienced economic growth for eight consecutive quarters and the pace of expansion this year is likely to average around 1.6% from 0.9% last year.  Most forecasters, including the ECB, expect that pace of growth,  of around 0.4% a quarter, to continue into next year and alongside  rising oil prices is projected to lead to a pick up in inflation , to 1.1% in 2016 and 1.7% the following year, and as such nearer the  target level. Recent developments in the exchange rate and the oil price may prompt a forecast revision, however, and the ECB has just flagged that it may take further policy action in December, contingent upon an updated inflation forecast.

Headline inflation. which had been negative early in 2015, turned positive in the Spring but has weakened again of late, with September recording another negative number (-0.1%). Energy prices fell by 1.7% in the month and are down some 9% on an annual basis, which  of itself reduces the overall inflation rate by 1 percentage point. Core inflation is also weak, however; prices rose by just 0.9% if one excludes food and energy while inflation in  services, which accounts for over 40% of the index, is just 1.2%.

The current ECB forecast is predicated on a rise in oil prices to an average of $56 a barrel next year, but this now looks too high; the current forward price of Brent implies a figure around $52. Moreover, the ECB expects the euro to average $1.10 , and as such are clearly concerned about the currency’s recent performance, with a 7.5% appreciation against the dollar since the Spring, taking it above $1.13 from below $1.06, and a 6.5% rise in the trade weighted exchange rate. Consequently, the forecast price of oil in euro terms of €51 now looks wrong on two counts, and may be closer to €46 in the December forecast in the absence of a significant fall in the euro on the FX markets.

Engineering such a fall may be difficult in the absence of stronger US data and a tightening of monetary policy by the Fed but the ECB is likely to take some measures. President Draghi took a step in that  direction at today’s press conference by opening the possibility of a cut in the rate the ECB pays for overnight deposits from the banking system. The Deposit rate was cut to -0.2%  over a year ago and Draghi had indicated that it was at the effective lower bound but that may no longer be the case, judging by his latest remarks.

Apart from a Deposit rate cut the ECB has also indicated that it will use other instruments to ease policy further if deemed necessary. The simplest. and most likely, is an expansion of the current asset purchase scheme , which could take the form of a higher volume of monthly purchases , a broadening of the assets deemed eligible or a prolongation of the time frame of the programme.

It may well be that we are at the effective limits of monetary policy, and further QE may be both ineffective and political troublesome for the ECB, as it carries implications for income distribution. Some council members have talked about the need for non-policy measures and it may well be that the whole fiscal policy debate will be reopened but for now the ECB remains the only game in town.

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.