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Inflation Could Push Oil Supply Into The Danger Zone

Concern about crude oil supply began to show around the time some central bank policy observers started warning against taking inflation trends lightly, as something transitory. Since then, both the oil supply situation and the inflation situation have deteriorated fast. Forecasts that Brent crude will reach and top $100 this year now sound a lot more plausible than they did in November. The supply issue is in the focus of attention as most OPEC+ members appear to be struggling to reach their assigned production quotas. Yet geopolitical tensions after the Houthi attacks on the UAE and the situation around Russia and Ukraine have substantially added to upward price pressure.

In the meantime, the United States booked a 7-percent inflation rate for December, which was the highest in four decades. In the UK, inflation reached the highest in 30 years at 5.4 percent. In the eurozone, consumer prices jumped by a record-breaking 5 percent in the same month.

"It could be the cherry on the inflation cake if we don't get a moderation in energy prices," Frederik Ducrozet, a strategist at Pictet Wealth Management, told Reuters last week. "This time it's a bit different because we're already at a point where the risks are tilted up and central banks are worried about a wage-price spiral since energy prices contribute to second-round effects."

The oil price rise really could not have come at a worse time for central banks, which are preparing to start winding down the stimulus they dispensed generously during the worst of the pandemic to keep their economies going. That stimulus had to end sooner or later, but now, with inflation where it is, there is fear, especially in the United States, that the wind-down could cause a debt crisis and it would be an international one.

Related: Turkey Hit By Unprecedented Power Outages As Iran Halts Gas Flows

The link between crude oil prices and the prices of everything else has been intimate since the dawn of the fossil fuel era. Whenever the price of oil—and gas, as we recently had the chance to see in Europe and elsewhere—rises for whatever reason, the prices of everything else rise too. And if there are also additional drivers for higher consumer prices, the picture becomes quite grim, and taming inflation becomes a bit harder.

In this sense, the problem with OPEC's spare capacity and Russia's apparent struggle to boost production as much as stipulated in the OPEC+ agreement is another cherry on the inflation cake that could make it very bitter. And that's the inflation in developed, less energy-intensive economies. Incidentally, these same economies have been budgeting for much cheaper oil.

According to a Reuters analysis, the European Central Bank had assumed an average Brent crude price of $77.5 per barrel for this year, falling to $69.4 by 2024 no doubt thanks to the surge in renewable energy capacity and the mass adoption of EVs that will kill millions of barrels in oil demand. This is a good illustration of how precarious forecasting the future, even the near future, actually is, especially if you base your projections on desired rather than realistic outcomes.

Since the start of 2022, despite the surge in Covid infections, crude oil prices have gained 10 percent, confirming OPEC's expectations that the effect of the Omicron virus on oil demand will be short-lived and, as such, insignificant. And they may have further to go even if the geopolitical hotspots cool off, all because of that OPEC spare capacity problem.

The cartel has been undershooting its production targets for months, and that's despite higher prices, which would normally spur everyone into action to pump more. But if even higher prices cannot motivate OPEC members to fulfill their quotas, there must be some bigger problem: the problem of dwindling spare capacity.

The less spare capacity for oil production there is in the world, the bigger the risks for the security of supply as demand growth shows no signs of abating for now. This, in turn, means continued inflationary pressure from the energy segment, interfering with central bank efforts to tame consumer prices.

Plans were in place to start raising interest rates even before the latest oil rally began. Cheap money had to end sometime. But as the Fed and other central banks begin to raise rates now, one unintended effect might be making a grave situation worse by adding higher borrowing costs to higher energy and consumer prices.

And it could be just the beginning because, in addition to lower spare production capacity, there is also another problem with future oil supply: underinvestment, driven by the ESG trend that discouraged more spending on new exploration. With Big Oil majors such as BP, Shell, and Total moving away from their core business in response to the demands of ESG investors, oil production in the medium to long term is set to decline. And if demand surprises forecasters again by not declining as much as expected, we're looking at an extended period of high prices.

By Irina Slav for Oilprice.com

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Irina Slav

Irina is a writer for Oilprice.com with over a decade of experience writing on the oil and gas industry. More