Oil prices at $80 a barrel are, in theory, good for the budgets of major oil-exporting countries. But prices at their highest level in three years could soon prove to be too good to be true for producers. Major importers generally draw the line at $80 oil, while the recovering global economy may be unable to sustain soaring energy costs with higher oil prices on top of record prices of natural gas, coal, and electricity in both mature economies in Europe and developing economies in Asia.
As soon as oil briefly hit $80 a barrel on Tuesday - the highest level in three years - the pullback in the market began amid concerns that the high prices would dent demand.
Global oil demand is actually strong and set to strengthen into the winter due to a gas-to-oil switch amid surging natural gas prices and low gas inventories in Europe and Asia just ahead of the heating season. Analysts and top executives in the industry see demand worldwide returning to pre-COVID levels as soon as early next year, if not earlier, by the end of 2021.
Fundamentals - recovering demand amid a muted supply response - point to prices potentially going even higher from here, say Goldman Sachs and commodity trading giants Trafigura and Vitol.
However, analysts have also started to warn that $80 oil is the price point at which demand destruction begins.
Major Asian crude oil importers, China and India, are not happy with $70-plus oil, as they have suggested many times over the past few years. In addition, oil nearing three-year highs is the last thing the global economy needs now that it is recovering but still plagued by supply chain bottlenecks and high energy costs reducing consumers’ purchasing power and denting profit margins of industries with high operating costs. $80 oil rekindles fears of runaway inflation that may not be as transitory as the Fed and central banks would like to see.
Oil Headed To Demand Destruction Point
One of the first warnings came from Morgan Stanley, which says that prices are headed to “the level where demand destruction kicks in, which we estimate at ~$80/bbl.” Morgan Stanley said this in June and noted this week, as carried by CNBC, “This remains our thesis.”
Morgan Stanley’s analysts Martijn Rats and Amy Sergeant acknowledged in a Tuesday note that global inventory draws in the past month are much higher than in the previous months and “suggest the market is more undersupplied than generally perceived.”
Fundamentals may point to a tightening market, but the $80 threshold is too big a deal for consumers to ignore.
Major Asian Oil Importers Signal They Are Not Happy With $80 Oil
The largest oil importers in Asia—China and India—have shown in the past few years that $70 oil and higher puts much upward pressure on their raw material costs and inflation. Both countries are selling crude from their strategic petroleum reserves these days. The sales haven’t had a major impact on global oil prices, but they have sent a strong message to OPEC+ and to the market that major crude importers want to ease inflationary pressure on materials and costs at a time when supply chain disruptions are also pressuring costs upwards.
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“While impact of China’s virgin SPR auction on global markets may be small, it does signal a major shift in how China likes to employ its SPR and potentially influence the behaviours of key suppliers,” Wood Mackenzie senior consultant Alex Sun said last week.
“At over $70/bbl, crude appears to have become too expensive for Beijing and New Delhi. Although this development has not impacted the global oil balance, it sends a strong message. Oil prices hitting $80/bbl will be a severe pain point for these key crude buyers and is likely to undermine import demand,” PVM Oil Associates said in a Wednesday note.
Oil Stoking Inflation Fears
It’s not only major importers that are unhappy with $80 oil.
Energy-intensive industries, especially in Europe, are already suffering from the sky-high prices of natural gas and electricity, with some curtailing production amid unsustainable costs.
High prices of energy commodities, including of crude oil, are set to further raise inflation which is already higher than Fed and central banks’ targets. Currently, inflationary pressures are seen as mostly transitory. Yet, sustained high oil prices would put more pressure on prices.
“Inflation is elevated, largely reflecting transitory factors,” the Fed said in its FOMC statement last week.
Inflation will eventually moderate, but current upward pressures are “frustrating” and could last into 2022, Fed Chairman Jerome Powell said at the annual forum on central banking organized by the European Central Bank.
“It’s also frustrating to see the bottlenecks and supply chain problems not getting better — in fact at the margins apparently getting a little bit worse,” Powell said, as carried by CNBC. “We see that continuing into next year probably, and holding up inflation longer than we had thought.”
PVM Oil Associates, commenting on what it described as a “premature celebration” of $80 oil, said on Wednesday:
“Another pitfall of higher energy prices is that it will spur already-heightened inflation. Rising oil prices have been one of the biggest drivers of inflation. And a worsening inflationary situation will act as a drag on the fragile economic recovery and oil consumption. This brings us neatly onto the issue of demand destruction.”
By Tsvetana Paraskova for Oilprice.com
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A fair price for Brent crude is $100-$110 a barrel. Such a price is good for the global economy because it stimulates the growth of the three ingredients that make the economy, namely, global investments, the global oil industry and the economies of the oil-producing countries.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London