Hydrocarbons Benefit From Rising Geopolitical RiskCrude oil came close to a triple-digit price last week for the first time since 2014. Natural gas prices have soared in Europe and Asia, and US prices rose to the highest level since 2008 when the February NYMEX futures contract spiked to over $7.30 per MMBtu in late January.
The chicken and egg economic dilemma may be, which came first, inflation or rising energy prices?
Energy prices continue to trend higher
Russian incursions into Ukraine could cause price spikes
US energy policy inhibits new production
Rising energy prices are a root cause of inflationary pressures
Expect lots of volatility- Watch crude oil at the end of March
The tidal wave of central bank liquidity and tsunami of government stimulus that followed the worldwide COVID-19 pandemic ignited an inflationary fuse. As prices began to rise, the shift in US energy policy to address climate change poured gasoline on the inflationary fire. In January, the consumer price index rose to 7.5%, and core CPI, excluding food and energy, was 6.0% higher, the highest level in over four decades. While the core number omits energy prices, energy is an input cost for goods and services measured in core CPI. The producer price index rose by 9.7% in January. The bottom line is that if rising energy prices did not ignite inflation, it is fanning the flames.
Meanwhile, based on a 7.5% inflation rate, the US Fed would need to increase the short-term Fed Funds rate by twenty-five basis points thirty times for real rates to be at zero percent. While the Fed may choose to increase the short-term rate by 50 basis points at the March FOMC meeting, the rise would be nowhere near the level that would push real interest rates out of negative territory.
While inflation pushes all prices higher, energy markets face two other issues that could prove explosive. OPEC and Russia now control crude oil pricing, and Russia’s expansionary actions threaten to make petroleum a political and economic tool.
Energy prices continue to trend higher
Last week, crude oil prices rose to new multi-year highs.
The monthly chart shows nearby NYMEX crude oil futures rose to $95.82 per barrel before pulling back to the $91.50 level at the end of last week. Crude oil continues to trend higher towards a triple-digit price. The current technical target stands at the June 2014 $107.73 per barrel high.
Nearby Brent futures on the Intercontinental Exchange, the pricing benchmark for two-thirds of the world’s petroleum production and consumption, reached $96.78 per barrel last week. Brent’s technical target stands at the June 2014 $115.71 high. In February 2021, NYMEX and Brent crude futures traded to respective highs of $63.81 and $67.70 per barrel.
At the $4.45 per MMBtu level on February 18, nearby NYMEX natural gas futures were well above the February 2021 $3.316 peak.
Meanwhile, thermal coal for delivery in Rotterdam at $162.35 was over double the February 2021 $68.65 per ton high.
The bottom line is fossil fuel prices have exploded, and the trends remain higher in early 2022.
Russian incursions into Ukraine could cause price spikes
The conflict between Russia and the US and its NATO partners is that the Russians consider Ukraine Western Russia, while the US and Europe believe the country is part of a free Eastern Europe. Russia has amassed over 150,000 troops along the Russian-Ukrainian border, and the US administration warns that an attack and incursion is “imminent.” While negotiations and discussions continued at the end of last week, President Putin is not backing down. The US and Europe have threatened severe sanctions, but Russia and China recently agreed on mutual support, making sanctions toothless.
Since 2016, Russia has become an influential nonmember of the international oil cartel. OPEC is not OPEC+ with the plus being the cooperation with Moscow. President Putin’s clever inroads into the cartel increased Russia’s sphere of influence in the Middle East together with alliances with the Syrian and Iranian governments.
OPEC does not make a move without Russian agreement these days, and a conflict that leads to sanctions could cause oil embargos aside from the logistical challenges created by war. Fighting in Ukraine could cause crude oil’s price to spike higher. Crude oil futures tend to take the stairs higher and an elevator lower. However, the current geopolitical environment increases the odds of a sudden rally. The oil market has not experienced an event-driven price explosion since the evening in August 1990 when Saddam Hussein marched into Kuwait and nearby futures doubled in a matter of hours.
US energy policy inhibits new production
In early 2021, US energy policy experienced an overnight transformation. On his first day in office, President Biden canceled the Keystone XL pipeline that transported petroleum from the oil sands in Alberta, Canada, to Steele City, Nebraska, and beyond to the NYMEX delivery point in Cushing, Oklahoma. In May 2021, the administration banned oil and gas drilling and fracking on federal lands in Alaska. Increasing regulations that address climate change favors alternative and renewable energy sources and inhibits fossil fuel production and consumption. Aside from handing pricing power back to OPEC+, the administration’s policy shift created entry barriers for new companies in the traditional energy markets.
Addressing climate change is a multi-decade initiative as the US and world continue to depend on fossil fuels for power. However, the administration appears to have put the policy horse before the cart as hydrocarbon output is not keeping pace with demand. According to the US Energy Information Administration, daily production at 11.6 million barrels per day is 11.5% below the March 2020 high. Moreover, oil and oil product stockpiles remain below the five-year average. Crude oil inventories were down 11%, gasoline was 3% lower, and distillate stocks were 19% below the average level over the past five years. While the US policies weigh on output, the demand is booming.
Rising energy prices are a root cause of inflationary pressures
After decades of striving for energy independence from the Middle East, the US energy policy handed the pricing power back to the cartel in 2021. As oil prices rose, the administration asked OPEC+ to increase output twice in 2021, but the cartel refused. In November 2021, the President released fifty million barrels from the US strategic petroleum reserve. The release amounted to three days of consumption, and the oil price continued to rally after reaching a higher low in early December.
While the pandemic-inspired monetary and fiscal policies and supply chain bottlenecks created inflationary pressures, the US energy policy has exacerbated the economic condition leading to an increasing cost of all goods and services.
OPEC+ suffered as US shale production increased over the past years. In 2022, it is payback time for the cartel as they would rather sell one barrel at $100 than two at $50. Meanwhile, in his standoff with the US and Europe, crude oil availability and prices are a negotiating tool and potential economic weapon for the Russian President.
Expect lots of volatility- Watch crude oil at the end of March
The higher the crude oil price rises, the greater the odds of a correction. The last downdraft in the crude oil futures market began in late October when the nearby NYMEX futures contract fell from $85.41 to $62.43 or 26.9% in six weeks. The $62.43 level was a marginally higher low than the August 2021 $61.74 bottom, keeping the trend of higher lows and higher highs intact. At the end of 2021, crude oil posted its seventh consecutive quarterly gain.
A quarterly chart illustrates a close above the December 31, 2021, $75.45 per barrel on the nearby NYMEX crude oil futures contract will mark the eighth consecutive quarterly gain. As of the end of last week, the price was substantially above that level.
Bull markets rarely move in straight lines, and the trajectory of crude oil over the past weeks has increased the odds of a correction and elevator ride lower. However, the geopolitical landscape, US energy policy, OPEC+’s desire for payback, and rising inflation continue to create an almost perfect bullish storm for the energy commodity that powers the world.
While many market participants are watching the $100 level, the potential for a challenge of the 2008 all-time high at over $147 per barrel in WTI and Brent futures could be on the horizon in the current environment.
Crude oil’s rise may result from monetary and fiscal policies and a political agenda to address climate change, but it has become a driving inflationary force. A more effective tool to stomp on inflation may be increasing US fossil fuel output to push prices lower instead of relying on monetary policy via interest rate hikes.
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