Volatile oil prices cast a shadow over the economy

It’s widely believed that inflation has peaked in most major economies and that interest rate cuts are likely to follow accordingly. In short, the economic outlook is improving, albeit only gradually.

But this cautiously optimistic view faces one significant downside risk. The price of Brent crude oil, the international benchmark, has been climbing all year peaking above USD 90 per barrel. Weakening economic data, particularly from the US, has brought oil prices back to around USD 85. But with shrinking oil inventories, we expect the upward trend to resume. 

While this is still well below the levels reached in 2022, when prices breached the USD 100 mark and kept rising, the current upward trend is fuelling fears that any recent economic progress might be reversed. That in turn would hit consumers, businesses and - in a key election cycle - incumbent politicians.

2024: a new year in oil

Oil prices have been rising steadily upwards so far in 2024, as geopolitical tensions - already high - ramp up further. Ukraine is using drone attacks to hit oil refineries deep inside Russian territory. After Iran's first direct attack on Israel and the corresponding Israeli counterattack on Iranian soil, there are growing fears that the war in Gaza could escalate into a wider regional conflict. 

At the moment, Iran seems to be playing down the significance of the latest strike, but if the situation spirals out of control, serious oil price hikes would be one likely consequence.

Fears of supply disruption are being stoked by cuts in production. The Organisation of Petroleum Exporting Countries (OPEC) and its allies, known as OPEC+, have agreed to extend a cut of around 2.2 million barrels a day until at least the end of June. This despite Russia and Iraq - two OPEC+ members - struggling to comply.

While supply side pressure builds, demand for oil will reach another record high this year. US economic resilience and increasing activity in emerging and developing economies will drive demand growth. Chinese demand will remain high but its growth is losing steam as momentum from reopening after pandemic lockdowns in 2023 fades. Car use is likely to climb as the spring and summer getaway season arrives in the Northern Hemisphere, adding to the pressure on oil supply.

The impact of expensive oil on industry sectors

Needless to say, reduced supply and increased demand are a recipe for inflation. Manufacturers, petrochemical firms, plastic producers, farmers, food processors and retailers, transport companies and supply chain businesses are forced to pay more for fuel, lubricants and oil-based components. These costs have to be absorbed - hitting profits - or passed onto consumers in higher prices.

Rising oil prices also directly affect consumers through higher petrol and fuel costs. And for every 1% increase in oil prices, food commodity prices rise by 0.2%, according to the International Monetary Fund (IMF).

Rising oil prices undermine already low margins in the food sector, with downstream food retailers most likely to be hardest hit. Consumers in the Asia Pacific, for example, are extremely sensitive to price, so the value chain will have to absorb most of the extra costs incurred by oil price inflation.

Globally, this is unlikely to significantly increase credit risk in the sector in the short term - food is too fundamental for that - but a mixture of tighter margins and higher prices will add strain to businesses across the value chain. 

Some sectors and businesses handle oil price volatility better than others. In the US, transport companies are among the first to feel the effects of increasing oil prices. Smaller and more regional businesses will be hit hardest, but larger competitors are likely to be able to adjust more quickly. Costs will filter through the value chain and impact other industries if oil prices remain high for an extended period.

European transport businesses may be in a better position to deal with higher oil costs after the shock of 2022. Russia’s invasion of Ukraine caused a surge in fuel costs, and transport businesses responded by renegotiating diesel clauses with customers. Adjustments can now be made more regularly, meaning price increases are more quickly passed on to customers.

The chemical industry tends to absorb oil price rises quite well, with petrochemicals businesses quickly passing on price rises to value chains and end customers. The plastics segment might see decreasing earnings, but most businesses can handle that without any deterioration of credit risk. 

Global trade may take another hit

Rising oil prices pose an obvious risk to global trade. Quite simply, the more it costs to move goods across continents and time zones, the less that happens. Sea-borne trade is already reeling from the impact of Houthi rebel attacks on shipping in the Red Sea. In some cases, ships are being rerouted around the Cape of Good Hope, adding thousands of miles to journeys and driving up costs.

Higher oil prices are another issue that international businesses could do without. The World Trade Organisation (WTO) is still relatively optimistic, forecasting global trade growth of 2.6% in 2024. But it has warned that geopolitical tensions pose a significant risk to its outlook.

Inflationary pressure leads to political strain

When rising prices create problems for consumers and businesses, they create headaches for politicians, too. Globally, more voters will go to the polls in 2024 than in any previous year. After a long period of economic stagnation, they are looking for signs of revival.

If surging oil prices reverse inflation’s downward trend and persuade central banks to cancel interest rate cuts, governing parties could pay the price. Nowhere is that more true than in the gas-hungry US. Research from Oxford Economics finds that the USD 15 per barrel increase in oil prices since the beginning of the year will only shave a couple of tenths off year-on-year real GDP growth, making a significant political impact unlikely.

But real problems arise if the price reaches or exceeds USD 100 per barrel. If that happens, the odds of the Federal Reserve keeping interest rates higher for longer rise incrementally, with serious implications for the November presidential election.

“The Federal Reserve generally looks past fuel price fluctuations,” says Dana Bodnar, economist at Atradius, “but the longer prices creep upward, the more they feed into transportation costs. This further complicates the task of bringing stubborn core inflation back to the 2% target, requiring higher-for-longer interest rates.”

Around the world, voters and analysts are expecting interest rates to start falling from mid-year onwards. That might still happen, but if the inflation picture becomes more volatile, central bankers may decide to err on the side of caution.

Could oil price rises be temporary?

Still, very little is certain at the moment. The recent loss of momentum of the oil price surge in response to investor fears of higher-for-longer interest rates in the US, the world's leading oil consumer, demonstrates this. But oil inventories and production still appear to be falling more quickly thna demand, increasing the chances of further upward price shocks.

But whatever the eventual outcome, rising oil prices have set alarm bells ringing. Forecasters who were confident of slow but steady economic progress just a few months ago are now less sure. Geopolitical tension, surging demand and the politics of oil production have injected uncertainty into the global economy once again.