This quarter, we dropped the oil page from our Guide to the Markets.
There are always exactly 65 pages in the Guide, so when we want to add a page, we have to get rid of one. The process is, unfortunately, democratic, so when my younger colleagues wanted to add pages illustrating U.S. equity market concentration, the AI capital spending boom and dollar weakness and international equity outperformance, I had to surrender the oil page.
But I did so with all the foreboding of well-grizzled experience.
While oil prices have been slowly trending down for some time, the most accurate metaphor for oil prices has always been a rollercoaster rather than a slide. Although lower oil prices could reduce inflation pressures in the months ahead, history suggests that low prices are hard to sustain and often lay the groundwork for another disruptive oil price spike. Consequently, both investors and the Federal Reserve should look past oil prices in judging the true trajectory of U.S. inflation.
Oil prices actually rose last week, as traders considered the potential impact of new U.S. sanctions on Russian oil companies. However, this rally was very much against the trend, which has seen oil prices in October fall 16% year-over-year, reaching their lowest levels, in real terms, since December of 2020.
This decline in oil prices has helped keep overall inflation somewhat subdued, with last Friday’s CPI report showing a lower-than-expected 3.0% year-over-year increase. In addition, according to the October Short-Term Energy Outlook published by the Energy Department’s Energy Information Administration (EIA), we could see even lower oil prices in the year ahead, as markets grapple with a growing glut in global inventories.
Jay Powell may well mention this benign oil price outlook, after this Wednesday’s FOMC meeting, as part of a justification for further easing. We expect the Fed to cut the federal funds rate by 0.25% at this meeting, implement a similar cut in December and cut at least twice more in 2026, reducing the lower bound of the target range for the funds rate to 3.00%, which is the Fed’s current estimate of the “neutral” rate. We also expect the Fed to announce an end to its quantitative tightening program at this week’s meeting.
However, while a further short-term slide in oil prices seems quite plausible, sustained low prices throughout next year are less likely. Just as high oil prices promote conditions for their decline, low oil prices will gradually mop up surplus production, setting the stage for a rebound.
A Forecast of Cheaper Oil
The EIA’s oil price forecast is remarkably bearish.
In their short-term outlook, released on October 7th, they projected WTI crude oil prices falling from $64 per barrel in September to $49 in January and staying below $50 throughout 2026. This, they estimate, would cut the price of gasoline to $2.76 a gallon in January, with prices staying below $3.00 for almost the entire year, reaching a low of $2.71 a gallon next December.
It should be noted that these projections are considerably lower than those priced into future markets, both when they released this forecast and today. For reference, they expect an average WTI price in 2026 of $46.50, 21% below the average priced into futures markets at the start of October and 19% lower than the average levels implied by today’s futures.
The EIA’s forecast of sharply lower oil prices starts by recognizing that global oil production is currently far outpacing consumption. Indeed, in the third quarter, while global production of liquid fuels reached 107.4 million barrels a day, global consumption was just 104.8 million barrels, thus adding 2.6 million barrels each day to global inventories1. A significant chunk of this appears to have been due to Chinese purchases as China is adding to its strategic stockpile, although China doesn’t release data on its oil inventories. More concretely, OECD inventories at the end of the third quarter were 2.878 billion barrels, up 3% from 2.794 a year earlier.
Another angle on this is provided by the energy consulting firm Vortexa2, who estimate that there is now more than one billion barrels of oil afloat in tankers, the greatest such stockpile since at least 2020.
A few factors have contributed to this growing glut.
First, the OPEC+ group of 8 nations, and most notably Saudi Arabia and Russia, have steadily increased their output this year, as they unwind cuts put in place in 2022 and 2023. At their October 5th meeting, they agreed to increase output by a further 137,000 barrels per day despite widespread evidence that, absent Chinese stockpiling, which can’t continue forever, oil production is running well above demand.
This policy would seem to be self-defeating. However, the group may deliberately be trying to boost their market share by lowering prices to a level which makes new non-OPEC production uneconomical. Or they could be trying to appease the U.S. President, who wants lower gasoline prices to mitigate the inflationary impact of tariffs.
Other factors contributing to the glut are significant increases in output from non-OPEC producers, relatively sluggish global economic growth earlier this year, continued output from Iran, Russia and Venezuela, despite U.S. sanctions and the lack of any major weather disruptions over the hurricane season.
The Potential for a Rebound
All of this being said, there are factors that could support prices going forward.
Last Wednesday, the U.S. announced new sanctions on Russia’s top two oil companies, Lukoil and Rosneft. As has been the case with other U.S. sanctions, Russia may gradually find workarounds to sell its oil, including avoiding dollar settlements and disguising its shipments as coming from “unknown traders”. China and India may still quietly facilitate Russian oil sales. However, just as is the case with Iran and Venezuela, the Russian sanctions remind us of the precarious political situation in many oil-producing nations.
Second, lower oil prices and depletion of easily accessible shale oil reserves could result in a significant decline in U.S. shale oil output. In a March survey, conducted by the Dallas Fed, shale oil producers reported that, while prices between $26 and $45 a barrel were sufficient to cover their operating expenses on existing wells, prices between $61 and $70 a barrel were necessary to make new wells profitable. Given the short life cycle of shale oil wells, low prices could quickly result in a reduction in U.S. output.
And, third, it is not clear how long the OPEC+ group will be willing to countenance falling prices. While, as is the case with any cartel, it is always difficult to discourage overproduction, the reality is that both Saudi Arabia and Russia are running significant budget deficits and have an urgent need for higher oil prices. They may, in deference to the U.S. President, facilitate lower prices until after the U.S. midterm elections. However, they will have a very strong incentive to drive prices higher at that point, and may, due to the response of non-OPEC production to lower oil prices, be in a position to achieve this.
Finally, any stabilization in global oil prices requires a reasonably healthy global economy. While many have worried about the impact of tariffs on the global economy, last week’s flash composite PMIs showed solid gains in both the U.S. and Europe, with only a small deceleration in a very strong Indian economy and still slow but steady growth in Japan. While the global economy isn’t booming, it now appears to be growing fast enough to generate a rising demand for oil.
Oil and the Fed
Because of this, it is unlikely that oil prices will fall as low and stay as low as is suggested in the EIA projections. However, it is worth emphasizing that this is an important issue for U.S. inflation and thus monetary policy.
Assuming no further fiscal stimulus beyond that which is already in the pipeline, incorporating last Friday’s CPI release, and adopting the futures’ markets current forecast for oil prices, suggests year-over-year gains in headline CPI of 3.3%, this December, 3.5% next June and 1.9% in December 2026. However, using the EIA’s lower forecast of oil prices instead suggests readings of 3.2% in December 2025, 3.3% in June 2026 and 1.8% in December 2026.
All of these numbers are about 0.3% higher than the equivalent personal consumption deflator inflation rate targeted by the Fed and if this weaker oil price path were to materialize, the Fed might be willing to go beyond cutting the fed funds rate to a neutral 3.0%, particularly later next year.
This is not our forecast. However, it does open up a tantalizing possibility of a lower path for both inflation and U.S. interest rates, providing a further boost to the current rally in U.S. stocks and bonds and further downward pressure on the U.S. dollar.
Whichever way it goes, chances are that oil markets won’t remain irrelevant for long and we will soon have to add the oil page back to the Guide to the Markets.