Market Musings 300923
Should we worry about rising oil prices today?

“Black gold” remains a key geopolitical lever for autocrats

Summary

• A sharp spike in crude oil causes concern

• But remember the tax take

• Plus refining, marketing and distribution costs…

• Refining margins can also vary a lot over time

• High prices can be the solution to high prices…

• Why crude oil will not spike above $100 (for long)

• Conclusions: don’t panic!

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All my recent podcasts can be found on Apple podcasts (search for “BNP Paribas Wealth”) or Spotify (click on link here).

A sharp spike in crude oil causes concern

Brent crude, the benchmark crude oil price, has risen from $74 a barrel to $92/barrel today, in the last three months since July. There is a similar story if you look at the benchmark crude oil price West Texas in the US which also has risen by about 27%, to a similar price in the 90s today.

Brent crude oil +27% from March low

Source: tradingview.com

Why is this a problem? Well, because it's true that historically, inflation has tended to correlate closely with the oil price. And that's quite understandable given our dependence economically on energy.

But remember the tax take

But we should also remember, before we panic too much about rising crude oil prices, that even in the US, the gasoline price is only 50% driven by the crude oil price and 13% by taxes.

Decomposition of US gasoline price by component

Source: EIA

The rest is what we call refining, marketing, and distribution costs. Now, if you think about Europe, let's take the example of France, in fact the tax hit is of course much higher.

Decomposition of French diesel and petrol prices by component

Source: UFIP Énergies et Mobilités

It can be about 55-60% of the final retail price for petrol or diesel.

So if we take today's price of around EUR 1.97 for diesel, over EUR 1.10 of that is simply taxes. In France, the largest oil-specific tax is called the TICPE, which is a specific petroleum tax. On top of that you have the usual value added tax VAT at 20% - altogether, roughly 60%.

Plus refining, marketing and distribution costs…

Then you have refining, marketing and distribution, which is probably around 20%. Which means that the final pump price is only driven 20% by crude oil prices.

So even though crude oil prices may have risen by 27%, what does that really mean for the pump price? Well, it means other things being equal, that the pump pressure you go up in Europe by let's say somewhere between 5-6%

What is the final hit at the pump, then?

So it's not great for the consumer, but it's not that big a hit. Actually it is nothing like as big as you would think.

In the US, you do expect to see a bigger hit. So a 27% rise in the crude oil price, other things being equal, should translate into about a 13% rise in the final pump price in the US given that 50% of the retail price comes from crude oil.

Refining margins can also vary a lot over time

But we should also remember that this is all other things being equal - but in reality, they're not always equal. In particular, refining margins, the cost of refining crude oil into various oil products like petrol gasoline, thicker types of lubricating oils and other products, can also vary a lot over time.

So you can sometimes see some offsets and in this case, we are seeing quite an offset because we have started to see lower refining margins, particularly in the US.

To the extent where if you look at the regular petrol price, and you can observe this using RBOB futures contracts, it has actually fallen at the same time as the crude oil price has risen. Which sounds a bit weird, but the difference is that refining margins have fallen quite sharply, and that's what has allowed the petrol price to fall even as the underlying crude oil price has been rising.

US gasoline futures fall even as WTI crude rises

Source: tradingview.com

High prices can be the solution to high prices…

Remember that there is also elasticity in demand relative to the price. What does that mean? That means in layman's terms, particularly when the price goes up a lot, demand tends to fall in response - because we as consumers react, we consume less of something when it's more expensive. That is called elasticity of demand.

And that is true of petrol and oil products. There is some demand which of course, is pretty constant, i.e. if you need to call to go to work, you still need to go to work, you still need to use your car, but we might cut back on other journeys which are not essential. And that is where this elasticity comes from.

Which of course also suggests that when you have these higher prices, you then get lower demand as a result. Over time that should then allow the price to fall back, because price is set by the balance between supply and demand. So if demand falls and supply doesn't change in theory, then the price should fall back.

This is something we observe particularly with commodity prices. It is often said in commodity markets generally, that the cure for high prices is indeed high prices, because demand will react and fall as a result of that high prices, which in time then brings down those high prices.

Sharp oil price spike often followed by price collapse

Source: tradingview.com

Why crude oil will not spike above $100 (for long)

Why do I think the crude oil price can actually stabilise here at around these levels, and not surged beyond $100/barrel?

There are several possible reasons:

1. Firstly, we are seeing advanced economies showing weak growth, including stagnation in Europe. In the US, even though growth looks strong, it is actually weakening and I expect it to weaken quite a bit more over the next three to six months.

2. Add to that you have seen the end of the tourist season in Europe. The weather is getting colder and the holidays are over. The same in the US where you see the end of so-called driving season, where people tend to drive a lot for holidays. That's now over. It's back to work back to school and as a result, petrol and diesel demand tends to fall a little bit.

3. US heating oil demand: remember that heating oil, which is a bit like diesel, is seeing some substitution. So in other words, to some extent, companies and households can choose to heat themselves with gas or heating oil. Heating oil is expensive, and gas is cheap today in the US. People can switch to gas, and that's what's happening. This should bring down some of the demand for oil generally, because of this switching out of heating oil into cheaper gas.

4. The OPEC countries and in particular, Saudi Arabia and the United Arab Emirates can add back production. Remember that the OPEC+ countries, predominantly Saudi Arabia and Russia, had reduced their production quotas. And that has been one of the motives behind the higher oil price. But equally well, the Saudis and the Emirates could add back production for simple reasons. They don't want prices to go too high. Because if oil prices get too high you can provoke an economic recession. If you promote economic recession, demand falls and then the price falls. So it is actually in the interests of oil-producing countries such as the OPEC cartel nations to maintain prices at a high level, but at a high level that can be readily accepted and absorbed by oil users. We don't want you to get so high that it provokes a recession and triggers demand destruction or lower demand.

I think at this level around where we are now is okay. If, however, prices were to go substantially higher, then I think the risk of recession and demand destruction would get that much greater. And that is what OPEC countries ultimately want to avoid, because it's not good for them either.

Conclusions: don’t panic!

So to summarise, if we look at crude oil prices, yes they have gone high to over $90 per barrel, but we think it can stay here but not necessarily go higher, for the reasons I've just given.

If we look at the effect on the consumer on inflation, it's not anything like as bad as you think particularly in Europe, where the tax burden is 60% of the total pump price. Remember, it's not just crude oil prices but also refining, marketing and distribution costs that we need to take into account, which are a substantial slug of the overall price.

Even in the US where the tax burden is lower, the crude oil price only represents 50% of the final petrol pump price. So again, the impact is not as great as you might think.

We should also think about energy demand in general and energy costs. In general, one thing in Europe that is very important is that since last year, when we saw a massive spike in electricity and natural gas prices, we've seen natural gas electricity prices fall back pretty quickly.

And it is the case that gas storage in Europe is actually 95% full already, well ahead of the usual seasonal schedule. So that suggests that in fact, as long as the weather remains relatively mild in Europe, we will have low gas demand and this will keep gas prices low. In turn, these lower prices will have a knock-on effect to electricity prices, which should keep low as well because they are highly correlated to natural gas prices.

So even if petrol pump prices are slightly higher in Europe, there is an offset in the broader energy sense because we are seeing lower gas and electricity prices at the same time.

Overall, I don't think we should worry too much about energy inflation just because of a higher crude oil price in the short term.

In fact, I think one of the conclusions here is one can still be invested in the various forms of energy, whether it be the energy sector, whether it be renewable energy or energy infrastructure. I think all of these investments are still relatively attractive at this level.

I think that even if the oil price doesn't go higher, it is likely that energy prices will stay at a relatively high level for an extended period of time. Because one thing is sure, I do think we've exited a long period when energy was abundant and cheap.

We are now in a period in the future where energy will be on average, much more expensive than has been in the past. As there is no longer this abundance of oil and gas,but instead there actually are emerging shortages of energy supplies in various parts of the world, at a time when large developing and middle-income countries like India and China continue to experience growing energy demand per capita.

Hence why I think structurally investment in the various forms of energy still makes a lot of sense, because I do think that these energy prices are not going to go back to where they were on average prior to 2020..

Bonne chance!

Edmund