One of the most important market developments in recent weeks has been the oil price rally. Brent has hit levels not reached since June 2015. The rally has been driven by several factors, including: 1) the prospect that, on 30 November, OPEC, Russia and nine other countries will extend their production cuts to the end of 2018 (from the current date of end-March 2018); 2) geopolitical tensions in the Middle East, particularly between Saudi Arabia on one side and Iran and Yemen on the other side ; and 3) better-than-expected economic figures in the US and in the Eurozone.
Are oil prices likely to go even higher? No, not really. In its annual report released on Tuesday the International Energy Agency (IEA) said that the United States was on the verge of becoming “the undisputed leader for oil and gas production” and that expansion in US oil output from 2010 to 2025 will have been historically unprecedented (in particular, the IEA expect the oil supply boom in the US over the period 2010-2025 to be stronger than in Saudi Arabia over the period 1966-1981). The US Department of Energy itself forecasts robust growth in US oil production in the coming months. Increased US output will keep prices in check. And, in any case, Saudi Arabia has served notice that it doesn’t want prices to rise too much.
Higher oil prices have not been accompanied by a depreciation in the US dollar, and there has been a true change of paradigm in correlations. In the past 15 years, the USD has generally been reversely correlated to oil prices. This is much less the case today as the US are switching from a situation where it was net oil importer to a situation where it will be net oil exporter (the IEA expects this to happen in 2027). Since the start of September, the dollar and oil prices have both risen. The correlation between the EUR/USD parity and oil prices is currently close to zero. Even the correlation of the USD/CAD (the Canadian dollar being an oil-related currency) and oil prices is much lower than during the previous decade. The Fed funds expectations have recently become the most decisive driver of the dollar. With slightly higher fed funds expectations, the dollar has a little more upside potential.
Otherwise, the recent oil price rally will make life easier for the ECB and, even more so, the Fed. Oil prices are 20% higher than when the ECB made its most recent economic forecasts, while the euro’s effective exchange rate remained stable, which could lead to an upgrading in ECB’s inflation forecasts in December. For the Fed, the basis of comparison on oil prices will be far higher beginning in November (released in December) and lasting for several months. When combined with the rise in core CPI to 1.8% after five flat months at 1.7%, this should make FOMC members more confident on the outlook for inflation.