Demand Can Sustain High Price — For Now

The old adage that the best cure for high prices is high prices will be put to the test in oil markets. Rising oil demand has helped drive benchmark Brent crude's 33% increase since November. Some experts argue that oil is on its way to $100 or higher, but there is no guarantee that consumers will tolerate such prices. They could reduce consumption and induce "demand destruction." Identifying this tipping point in today's post-Covid-19 market is no easy task, but economists agree that a sudden price shock — like the one that has taken place recently in oil — has a bigger impact on consumption than a gradual increase that can be absorbed over time. Goldman Sachs, Bank of America, JPMorgan Chase, and Morgan Stanley are among those that think oil could hit $100 or higher this year. Part of Morgan Stanley's rationale is that demand destruction did not occur last year when oil breached $80 per barrel, as the bank had expected. In advanced OECD economies, elevated household and corporate savings are providing a spending cushion, which partly explains the current demand resilience. In the US, both Phillips 66 and Valero recently noted that road fuel consumption is back at or even above pre-pandemic levels. Vaccinations and the pandemic's fading have also unleashed pent-up demand for leisure travel in developed economies. But in emerging markets, which are more critical to oil demand growth, consumers generally do not have the same financial buffers, although some governments in Asia are offering some protection by keeping subsidies in place and retail fuel prices artificially.

Higher oil prices can have an indirect impact on oil demand by stalling the economic recovery from the pandemic and fueling inflation. Higher prices will take a toll on household and business budgets, ultimately slowing economic growth. This is particularly true in emerging markets where countries buy oil in US dollars. The dollar is expected to strengthen and will make imported oil more expensive for these nations. And as high oil prices drive inflation, central banks must prepare interest rate hikes to cope, which can curb economic growth. Not surprisingly, China and India, the world's first and third-largest oil consumers, were first to complain that prices were rising too high last year. However, they were rebuffed by Opec-plus, which did not raise its crude output beyond already-agreed volumes. Saudi Arabia's Crown Prince Mohammed bin Salman this week told Japanese Prime Minister Fumio Kishida in a phone conversation that the kingdom would contribute to the stabilization of the global oil market, but Opec-plus' options look limited given its dwindling spare capacity. Opec-plus member Kazakhstan even experienced an uprising over higher fuel prices. The US is concerned about inflation and the cost of gasoline for consumers. US gasoline is just 3% of the inflation index but accounts for at least 50% of price swings. Higher inflation is forcing central banks to raise interest rates, which increases borrowing costs and can slow economic growth. The International Monetary Fund has lowered its economic growth forecast for 2022, but the global economy is still set to expand, and countries will need more energy to fuel this growth.

Speculators are betting on higher prices because they see strong demand while supply struggles to keep up. Meanwhile, geopolitical tensions threaten supply disruptions, adding a risk premium of about $5/bbl. There is not much standing in the way of the rally now, but oil balances suggest some of it could be froth. Oil prices could soften as some temporary price drivers should fall away soon. The winter in the Northern Hemisphere is getting closer to its end, which will lower demand for natural gas, and in turn demand for diesel and fuel oil as cheaper alternatives for power generation and industrial use. The arrival of spring will also lower demand for heating oil. Consumer sentiment is in the doldrums, falling to its lowest level since November 2011, and this does not bode well for sustained demand under high prices. Europe, like the US, gets increasingly agitated by higher prices at the pump. Peak summer demand is around the corner, and while people are eager to fly and drive more as the pandemic fades, high prices and greater concerns about climate change could factor. High prices could induce purchases of more efficient cars or electric vehicles.