The price of oil hit a three-and-a-half-year high after the US withdrew from a nuclear agreement with Iran. Schroder's experts examine the impact and what might happen next.
The oil price continued its surge towards the $80 a barrel level after President Donald Trump withdrew the US from the nuclear agreement with Iran.
He has also imposed tough sanctions which could prevent Iran from selling its oil to the rest of the world.
West Texas Intermediate (WTI), which is also known as Texas light sweet and is a grade of crude oil used as a benchmark in oil pricing, rose to $71.14 on 9 May 2018, its highest level in three and half years. It has gained more than 13% since the start of 2018 and is up 171% since its low of $26.21 on 11 February 2016.
A perfect storm of strong demand and restricted supply have combined to drive up the oil price. Demand has been particularly boosted by the two key markets of China and India as their economies continue to grow.
The constraints on supplies can be seen in oil inventories, which have fallen below their five-year average.
The limitations on future production have been particularly evident in shale oil, which is one of the fastest-growing areas of the industry. With regard to offshore production, authorised projects have now fallen to their lowest number in eight years.
Outside of this given the Organization of the Petroleum Exporting Countries’ (OPEC) unprecedented discipline the situation in Iran will only add to these supply strains.
Can the oil price rally last and how best to play it?
Mark Lacey, Head of Commodities, said: “The destocking in the second-half 2018 and the lack of sanctioned projects that start in 2019, barring a demand collapse, will leave market supply extremely tight.
“However, much of that supply constraint will now be priced into the market, meaning we could be nearing the top of the current rally, which will continue towards $80 per barrel.
“One way to play the oil rally could be to look at oil explorers and production companies.
“Many have committed to increasing dividends and returning money back to shareholders and most have worked out their budgets at $55-$60 a barrel.
“If the oil price were to remain above those levels, then these companies could have plenty of spare cash which they’ll need to decide what to do with.”
What effect could higher oil prices have on the global economy?
Keith Wade, Chief Economist, said: “In terms of broad economic effects, the rise in energy costs will bite into household incomes leaving less to spend on other goods and services.
“Some of this will be offset by stronger spending from the oil producers and companies linked to the industry, but the net effect is a drag on global spending and growth.”
“This could be a particular problem in the US, the world’s largest economy, where the cost of living has already been rising.
“Raising interest rates could help tackle the issue. However, the Federal Reserve faces a tricky task in tightening policy without triggering a sharp downturn, given the time lag between changes in rates and the effects on the economy.”
How might high oil prices affect emerging economies?
The impact on emerging markets will have differing effects on countries.
In general, those markets which are net oil importers, such as India and Turkey for instance, could face a headwind from higher crude prices.
Those which are net oil exporters, such as the UAE and Russia for instance, are likely to benefit.
Together with the overall balance (or imbalance) in each country's economy, the impact can be magnified. For instance, while Turkey is a net oil importer, its economy also has imbalances, including a large and widening current account deficit. As a result, the Turkish lira has come under pressure, exacerbating the costs of importing oil into the country.
What’s the bigger picture for oil?
The price of oil has enjoyed a period of relative stability in recent years. Ahead of the global financial crisis, a booming global economy helped pushed WTI to a high of $146, reached in July 2008.
It had been as low as $17 a barrel in 2001. The average price since the turn of the century has been $63.
Mark Lacey, Head of Commodities, said: “Aside from the recovery in the last six months, the price of oil has been relatively weak in recent years and this followed a sustained period of very strong oil prices, which stimulated a very high level of investment.
“We estimate that the current levels of investment are not sufficient to deliver enough supply to meet annual demand growth of +1.5 million barrels per day over the next few years.
“The recent increase in oil prices will stimulate investment, but this will take a few years to hit the market, which means that prices should remain well supported above the average cost of production (see chart below).
“The key driver of oil demand remains transportation. As a result, China and India remain the key growth areas in the short term, as passenger car sales continue to grow at extremely strong rates.
“Longer term, the impact of electric and hybrid electric vehicles will result in oil demand growth rates slowing and then eventually declining; but given the infrastructure constraints, this is unlikely to have an impact before 2030.”
This article has first been published on schroders.com.