Oil prices and inflation: what’s the correlation?
Crude oil bottomed in March. Over the last three months, the oil price has been on an upwards trajectory. There have been opposing demand and supply forces at work here. On the one hand, global oil demand is reaching record levels. On the other, OPEC+ and its policy of production cuts.
The International Energy Agency (IEA) writes, “World oil demand is scaling record highs, boosted by strong summer air travel, increased oil use in power generation and surging Chinese petrochemical activity. Global oil demand is set to expand by 2.2 mb/d to 102.2 mb/d in 2023, with China accounting for more than 70% of growth.”
Moreover, oil is also close to four-month highs off the OPEC+ oil cuts. Current production is near two-year lows according to a Platts survey by S&P Global Commodity Insights.
During July, the combined oil production of OPEC’s thirteen member nations reached 27.34 million barrels per day, and an additional 13.06 million barrels per day were contributed by Russia and eight allied countries. This totalled 40.40 million barrels per day, marking the consortium’s lowest output since August 2021.
In effect, the cut in supply and the potential apex in demand are feeding into oil price appreciation.
The Federal Reserve (Fed) has been hiking rates in its battle to attain price stability and achieve a target inflation rate of 2%. Of late, strides have been made, with headline inflation peaking in June 2022, coinciding with highs in the oil price.
Weekly Price Analysis
Source: Marketscope 2.0
Above we consider the weekly chart of FXCM’s USOil instrument as a proxy for the oil price. The shaded area shows price consolidations, where price effectively moved sideways. These are areas where there was an intermediate-term price equilibrium of sorts, which prohibited price from trending. Here, there was a broad agreement between the forces of supply and demand.
The red dashed vertical (beginning of July 2022) shows where the chart’s relative strength indicator (RSI) slips below 50, which is the bearish side of the indicator. Shortly thereafter the USOil price moves below its black 30-week exponential moving average (EMA) and the EMA turns down in confirmation, as the supply of oil exceeds its demand. As a result, the USOil price and EMA trend down, with the RSI remaining below 50.
There was a short whipsaw signal, which saw the RSI pop above 50 (black ellipse), and the candlesticks punch above the 30-week EMA. This was after OPEC+ group of countries said that they would slash production by about 1m barrels per day until the end of 2023. At the same time, Russia extended its existing cut of 500k barrels a day until the end of the year.
However, the supply cuts were still to work through the price mechanism. The EMA did not turn up to verify. As such, the RSI shortly dips back below 50 and the price dropped back below the 30-week EMA.
Nevertheless, it was a sign of things to come.
The green dashed vertical (beginning of July 2023) shows where the chart’s RSI pops above 50. This is the bullish side of the indicator. Shortly thereafter the USOil price moves above its black 30-week EMA, and the EMA turns up in confirmation. In effect, OPEC+’s supply cuts are skewing the supply/demand relationship and stoking the excess demand. This tilt is price supportive.
However, the higher crude price is setting off cautionary signals within financial markets, as there may be an inflationary by-product.
The Headline Inflation/ Oil Price Correlation
Headline inflation is closely correlated with the USOil chart. As inflation skyrocketed from 2020, UKOil tracked higher. Moreover, we see that the two series peaked at the same time in June 2022. The correlation coefficient is a robust 76%. This suggests that if USOil is showing signs of bottoming and strength, headline CPI may very well react upwards as well.
Oil prices ripple through to manufacturing costs, transportation of goods and as well as other touch points in the economy. When it comes to inflation, the oil price is a wild card.
Has the low hanging fruit been picked?
The Fed has been concentrating on its price stability mandate and has raised rates eleven times, since early 2022, in its efforts to cool inflation. By and large, their efforts have been successful, but the oil price has been cooperating with their efforts. This may have changed. The oil price is picking up again, which is likely to fuel inflationary pressures. This may suggest that in terms of its fight against inflation, the low hanging fruit has been picked and the last 100 basis points, to the Fed’s target, may prove to be a lot tougher.
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