Oil spike lengthens odds on getting to grips with inflation

From May through to the end of this year they will reduce output by approximately 1.15 million barrels per day. This comes on top of cuts of two million barrels per day that took effect in November, making for a total reduction of about 3.7% of global demand.

Though the cuts amount to only a small amount of the world’s daily usage, the impact on prices could be significant. This in turn would further fuel inflationary pressures in a period that has already been the worst for living standards in modern history, according to the TUC.

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The Saudi Energy Ministry said the reductions are a “precautionary measure” aimed at stabilising the market after oil prices fell to a 15-month low in March on concerns that turmoil within the global banking sector, along with rising interest rates, could hit demand. The move looks like a pre-emptive strike by Opec+ to keep a floor price under oil of about $80 per barrel in the face of an anticipated slow-down in the global economy later this year.

Ironically, analysts have warned that by further stoking inflation, the surprise decision to cut production will likely prompt monetary policy makers to keep interest rates higher for longer.

“The development comes as a blow for inflation, with expectations of inflation coming down partly balancing on the trajectory of the oil price,” analyst Sophie Lund-Yates of Hargreaves Lansdown said. “Markets are aware that if the pressure continues, central banks will need to extend or strengthen their interest-rate hiking cycles, the expectations of which will need to be repriced.”

Higher interest rates have been adding to the pressure on households and businesses since the Bank of England embarked in December 2021 on the most aggressive tightening of UK monetary policy in decades. Increases in the cost of borrowing after more than a dozen years of historic lows have come on top of double-digit inflation triggered by the emergence of the global economy from Covid lockdowns, and further exacerbated by Russia’s invasion of Ukraine.

In that sense, the move by Opec+ could have hardly come at a worse time for the UK, Europe and the US, all of which are battling to bring down the surge in the cost of living driven by higher energy prices. The big question is whether the increase in oil prices will stick, and on this point the experts are divided.

If the increase in oil prices further stokes recessionary fears, this will act as a natural dampener on demand and the rally could quickly fade. It is here that the emergence of China from its zero-Covid policy will prove critical in whether it can make up for weakening demand elsewhere around the globe.

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On the other hand, many businesses in the manufacturing and service sectors are already operating on the thinnest of profit margins after a year of absorbing cost increases rather than passing them on to cash-strapped consumers. There is no slack to absorb another round of high oil prices, so any increase in production and transport expenses will flow pretty much fully and directly into the cost of all goods and services.

The RAC has said it doesn’t expect an increase in pump prices in the short-term. It normally takes about a fortnight for oil prices to feed through to the price of petrol, so much will depend on whether yesterday’s spike is maintained in the coming days.

There is a further question mark over home energy bills which from this month will revert to full force following the end of the UK government’s Energy Bills Support Scheme which has returned £66 to every household in each of the last six months.

Last month’s Budget did extend by a further three months the £2,500 cap known as the Energy Price Guarantee, which limits the amount that households pay per unit of gas or electricity, until June. In this Chancellor Jeremy Hunt was gambling that declines in gas and electricity prices during the last several months are set to continue.

The wholesale price of natural gas has fallen by more than 70% since August of last year, and the correlation between the cost of gas and crude oil prices is limited. This is significant as most UK households are far more reliant on gas than oil for power and heating.

Among the immediate beneficiaries of yesterday’s surge in oil prices were energy majors Shell and BP, whose London-listed shares both rose by more than 4% to take the FTSE 100 into positive territory by the close of the trading session. North Sea giant Harbour Energy, which last month warned that the UK’s windfall tax has “all but wiped out” profits, saw its share price move nearly 6% higher.

READ MORE: Oil producers announce surprise cuts in move which could force up prices

The Bank of England and its monetary policy equivalents in Europe and the US are in a trickier position as officials were anticipating a significant fall in inflation on the basis that there will be no repeat of last year’s sharp increase in energy prices. The developments of the last 48 hours threaten to make this a more protracted affair.

"The move by [Opec+] is particularly unhelpful for central banks who, while being worried about sticky inflation, are becoming increasingly concerned about pushing rates up from their current levels,” said Michael Hewson, chief analyst at CMC Markets UK.

"These concerns are especially pertinent given recent worries about financial stability, as yields edge back toward their recent peaks."