OPEC Meeting Will Decide Direction Of US Inflation
Tomorrow a discordant group of nations will assemble in Vienna, Austria, to discuss their main product: oil. These are the members of the Organization of Petroleum Exporting Countries. And for the 33 years in a row, this meeting will include the original members, Middle Eastern States led by Saudi Arabia, and close allies, such as the Russian Federation.
OPEC planned this meeting months ago, but the timing couldn’t be better. OPEC’s largest customers, all in the northern hemisphere, are entering winter. The season with the highest energy demand. And just a few days ago, Northern Europe’s largest oil and gas supply, the Nordstream Pipelines, were permanently taken offline by a wanton act of terror.
This year has been a particularly bumpy ride for OPEC and all the world’s oil producers. As I said, the timing couldn’t be better. Europe’s benchmark oil, Brent Sea Crude, peaked earlier this year at nearly $130 per barrel. Today it trades at slightly over $80. That’s a price drop of one-third in just three months.
So, of course, OPEC is looking for strategies to bring back those higher prices. And the easiest way to do that is to reduce supply. Reuters is reporting that several oil ministers have indicated that they would like to reduce daily OPEC production by 500,000 to a million barrels daily. And most analysts agree that reduction would bring us back to those old prices earlier in the year, around $100 a barrel.
So far, this is a fairly straightforward story that we’ve seen play out for the past 50 years. Oil prices drop to a low level, OPEC reacts by restricting their production, and oil prices shift back to old highs. And that’s pretty much how Wall Street sees the current situation.
But there is a new twist to this old story that you and I need to recognize. If we think back to earlier this year, there has been one overriding story about this year’s economy: inflation. 2022 is the year of inflation. In the first quarter, inflation climbed steadily, finally peaking, if it is a peak, just recently in the late summer, early fall period. Oil prices also increased during the first quarter, consolidating in April and peaking in June.
That inflation and the price of oil moved together is no coincidence. There is a direct relationship between the cost of oil and inflation. The Bureau of Labor Statistics calculates that fully 40% of this year’s inflation is directly due to the cost of oil. And US Inflation in 2022 has now tracked oil prices for over a year.
You’ve already guessed the rest.
Let’s assume that OPEC decides to curb production. And that results in higher prices, say $100/barrel. And why wouldn’t they cut production? They could make the same revenue in today’s oil market by selling less oil.
It will take a few weeks for prices to adjust to this new reduced supply. But sometime around the end of the year, we should be looking at $100/barrel again.
Where do you think inflation will be, then? Remember, 40% of CPI comes directly from the price of energy. I think it’s perfectly reasonable to assume that, along with oil, inflation will be back to earlier levels, around 8% or 9%.
The Role Of The Federal Reserve
Up until now, our entire discussion has been about supply. In particular, the amount of oil on the market. However, there is one slight caveat to our scenario: the role of the Federal Reserve.
Now we need to turn to demand. And that’s the purview of the Federal Reserve. By raising interest rates, the Fed has reduced the aggregate demand in our economy. Higher interest rates increase the cost of all kinds of ancillary business expenditures. The cost to carry inventory, for instance, rises, as does the cost to finance capital goods such as plants and equipment. Consumers are less likely to purchase on credit as interest costs rise.
We’ve discussed before aggregate demand is falling, which will provide a secondary reduction in inflation, although a harrowing one. Demand destruction ultimately reduces the economy, closing down shops and factories that can no longer sell their goods and services.
The bottom line, the Fed’s high-interest rates will reduce overall demand. And this may reduce our target inflation rate (the one after OPEC raises the price of oil) by 1% or 2%. So let’s say that if oil rises to $100/barrel, inflation may “ only” rise to 7% or 8%. Slightly less than our original estimate (8% to 9%) due to the actions of the Fed.
Overall this doesn’t present a charming outlook for this winter.
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