A recent headline from the Financial Times captured the current state of the oil market succinctly. While those closely following the industry should not have been surprised, it clearly caught many off guard.
In July, we warned about potential risks in the oil market, indicating that “Oil prices head into a warning triangle.” Earlier this month, we raised concerns that “OPEC+ risks losing control of oil markets.”
The reaction to the Financial Times’ article points to a troubling trend: investors have been neglecting critical changes in the oil market. For the past month, their focus has been primarily on whether the U.S. Federal Reserve would lower interest rates by 0.25% or 0.5% at its September meeting. On the decision day, the odds were two to one in favor of a 0.5% cut, as reported by CNBC.
This trading scenario benefited those adept at capitalizing on market fluctuations. However, the interest rate adjustment was more about boosting voter confidence ahead of elections. It’s important to note that interest rate changes typically take 12 to 18 months to affect the economy fully. We are just now feeling the effects of the Fed’s rate hikes from March 2022 to July 2023, which raised rates from 0.25% to 5.25%. Consequently, this month’s cut is unlikely to have a significant impact outside of Wall Street.
Oil prices have a more direct effect on everyday consumers, commonly referred to as Main Street. As the Wall Street Journal’s data shows, oil prices have been declining for the past three months. The U.S. Energy Information Agency (EIA) reports that gasoline prices have also dropped during the peak summer driving season. In March, average gasoline prices were $3.67 per gallon, but they fell 13% to $3.19 last week.
Expect further price declines as OPEC+ works to regain lost market share. This development is noteworthy, especially with the potential for renewed conflict in Lebanon. Historically, during similar crises, like the one in July 2006, Brent crude prices surged from $67 to $78 per barrel before retreating to $51 once the conflict subsided.
This time, however, oil prices have been falling despite increasing tensions. What happens next is crucial. There is a clear risk of Iranian intervention, which could lead to the closure of the Strait of Hormuz. The EIA emphasizes the strait’s significance: it is a major chokepoint for global oil transport, with an average flow of 21 million barrels per day, accounting for about 21% of global petroleum liquids consumption.
If Iran were to take action, oil prices could skyrocket, potentially reaching $100 per barrel or more. However, if Iran remains inactive, prices may continue to decline due to OPEC+ strategies. They could drop back to $30 per barrel, reminiscent of past trends.
Such a scenario could trigger deflation, similar to what occurred in 2009. This time, however, we might face a more extended period of deflation, leading to significant shifts in consumer behavior. Many consumers have only experienced inflation, making it seem logical to buy now rather than later, expecting prices to rise. In contrast, deflation would encourage waiting to purchase, as prices would likely fall further.
Thus, developments in the oil market demand close scrutiny. Should prices dip below $50 per barrel, central banks might hasten to reduce interest rates significantly, further increasing the likelihood of deflation.
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