The outlook of energy prices over coming months is still a critical component in determining whether the current bout of inflation should calm going into 2022.
Chief Market Strategist, Asia Pacific
The rebound in energy prices has been driving inflation higher around the world. For example, in the U.S., energy and energy-related commodities were responsible for over 70% of headline inflation in 2Q 2021. Other supply-side bottlenecks such as semiconductor shortages and the difficulty in hiring staff as the services sector reopens are adding to price pressures. Nonetheless, the outlook of energy prices over coming months is still a critical component in determining whether the current bout of inflation should calm going into 2022.
Recently, the Organization of the Petroleum Exporting Countries and Russia (OPEC+) agreed to add 400,000 barrels per day (b/d) each month, starting in August until December 2022. This implies output would be raised by 2 million (b/d) by the end of the year. This decision was delayed due to differences between Saudi Arabia and the United Arab Emirates , which raised concerns that OPEC would not be able to agree to an output increase to meet growing demand. Hence, the agreement should provide investors some relief that the supply shortfall should be addressed.
The COVID-19 pandemic led to a collapse in oil demand in 2020, when Brent Crude price hit the low of USD 9 per barrel (pb) (Exhibit 1). According to the U.S. Energy Information Administration (EIA), global consumption of oil fell to 92.3 million b/d in 2020 from 100.9 million b/d in 2019. The reopening of the global economy as nations start to get the pandemic under control has allowed for oil demand to recover. The EIA projects that global consumption should recover to 97.6 million b/d in 2021 and 101.4 million b/d by 2022, above the pre-pandemic level. This has led to some destocking of crude oil.
This rebound in demand and the delay in expanding output has pushed oil prices to above USD70 pb. Hence, the latest increase in scheduled output should provide some downward pressure to energy prices. This is also reflected by the oil future markets, with a downward-sloping price curve over the next 12 months. In addition to the decision by OPEC+ to raise output, other producers have also stepped up their production, such as Brazil, Canada and U.S. Overall, this would imply the supply and demand of oil should be largely balanced as we enter 2022.
The outlook for energy prices are still subjected to the pace of the global economic recovery and any unexpected shocks from suppliers (e.g. geopolitical events, Iranian sanctions, weather-induced supply disruptions). Nonetheless, the risk of a sustained surge in oil prices as we enter 2022 is low. This would mean the year-over-year (y/y) contribution to headline inflation of energy prices should fade towards the end of 2021.
EXHIBIT 1: THE REBOUND IN DEMAND AND THE DELAY IN SUPPLY INCREASES HAVE PUSHED UP OIL PRICES
The current inflation challenge in the U.S. is not only brought by the rebound in commodity prices but also several supply-side factors trailing behind the rapid surge in demand. This includes companies struggling to hire workers to reopen their businesses to meet customers’ needs. Nonetheless, a stabilization in energy prices should help to address part of the inflation concern as the y/y boost in consumer price should ease going into 2022. The energy price stabilization should also provide the Federal Reserve some relief, as high energy prices hurt consumption as well as push headline inflation higher, which could create a dilemma when it comes to policy setting.
Inflation expectations could cool and this partly explains the lower U.S. Treasury (UST) yields in recent weeks, alongside with a range of technical factors (Please see last week’s “On the Minds of Investors – Why are bond yields so low?”). However, the current negative real yield environment is not consistent with the economic recovery and potential phase of quantitative easing in 2022. In short, we still expect UST yields to rise in the months ahead as investors reflect their expectations of economic recovery.
A stabilization in energy prices could slow the earnings recovery for the energy and material sector, but the ongoing volume growth should help to maintain earnings expansion. This might take some shine off the value rotation given the role of energy and materials in the value sector, but financials and industrials should still enjoy the benefit of the global economic recovery.