How much further have petrol and diesel prices to fall? And how will central banks respond to it?

Yesterday there were some extraordinary developments in the oil market as first rumours circulated and then OPEC (Organisation of the Oil Producing Countries) produced this statement.

Accordingly, in the interest of restoring market equilibrium, the Conference decided to maintain the production level of 30.0 mb/d, as was agreed in December 2011……..The Conference resolved that its next Ordinary Meeting will convene in Vienna, Austria, on Friday, 5th June 2015,

So, not only did it decide not to respond to falls in the oil price which had reached some 30% on a year before but the timing of the next meeting meant that no change was in the offing either.

Rout,slump or crash?

I will leave readers to pick their own paragraph heading for what happened next. The reality was that the price of a barrel of Brent Crude Oil fell 6% on the day to below US $73. The usual pattern after such heavy falls is for a market to dip again the next morning and we have seen that at the time of typing this as the price has fallen further to below US $72 so far today. This leaves the oil price some 35% below the level of a year ago and the consequences of that are my subject of today.

Inflation,Inflation,Inflation

Back on the 20th of this month I mentioned some research on this subject from the Cleveland Federal Reserve which told us this and the emphasis is mine.

there is some concern that low oil prices, which have continued to remain below $90 a barrel through October, will keep inflation persistently below or even push it further from targeted levels.

I would like readers to keep in their minds the idea of something (lower inflation ) which is good for them being of “concern” for central bankers, but the latest falls will have some important consequences. l summarised the UK situation with this tweet yesterday.

Dear Chancellor what is the form for writing to you about UK CPI falling below 1%? Yours Respectfully Mark Carney Governor

Just over a fortnight ago Bank of England Governor Mark Carney indicated that the subject was on his mind. From the BBC.

In a news conference at the Bank of England, Mr Carney said it was likely he would soon have to write a letter to the Chancellor, George Osborne, explaining why inflation had dropped below 1%.

I do hope that he has a proper fountain pen with which to sign what will be one of a kind at least initially. You see all the explanatory letters from the Bank of England Governor have been so far for above target inflation.

If we skip across the Channel to Europe there are consequences for the Euro area and the European Central Bank too. It seems rather likely now that we will see a 0% print for Euro area consumer inflation (CPI) and we could easily see a negative one.  This poses a real problem for the ECB which has set people’s expectations around the consumer inflation rate in what has turned out to be something of an own-goal. I still recall former ECB President Jean-Claude Trichet boasting about the CPI in the Euro area averaging 1.97%.

What is the impact on us?

The Office for Budget Responsibility (OBR) looked at this matter back in 2010 and concluded this.

A £10 a barrel rise in the oil price would raise the pump price of petrol and diesel by 7.4 pence a litre if fully passed through.

If we now look at the last year then the oil price has fallen by £22 a barrel so we would expect there to be a total fall in diesel and petrol prices at the pump of 16 pence. According to the official figures we have seen a 7.7p fall in the petrol price and a 10.6p one for diesel. Thus we should see a 8 pence fall in the petrol price and a 5/6p fall in the diesel price ceteris paribus.

We can take this further as the OBR gave us some benchmarks.

Road fuels have a weight of around 4 per cent in the CPI and 5 per cent in the RPI basket.

If we apply its benchmarks then according to its analysis the fall in the oil price would if you measured inflation today make it some 0.55% lower in terms of the UK official CPI and by 0.66% in terms of the Retail Price Index than a year ago. Of course some of this effect we have already seen but there is an additional factor raised by the OBR.

There could be an additional impact on inflation if higher oil prices lead to a rise in electricity and gas bills. Electricity and gas bills have a weight of 3.5 per cent in the RPI and 4.4 per cent in the CPI, so a similar rise in prices to that of road fuel could roughly double the impact on inflation.

They were discussing a rise here but if we assume some symmetry we see that we could now be discussing a 1.1% lower annual rate of CPI than otherwise and a 1.3% lower rate of RPI. That is before we discuss the second-order effects of such a move.

I counsel caution about the precise accuracy of such forecasts but we have a clear trend which hints that Mark Carney might like to make sure that his fountain pen has a ready ink supply! He may have some luck in January as prices fell by 0.6% this year on a monthly basis but apart from that should we remain in similar circumstances then as Glenn Frey put it.

It’s on the street
The heat is on, the heat is on, the heat is on
Yeah it’s on the street
The heat is on

What about Europe?

Earlier this year the European Parliament took a 232 page look at energy prices and in the context of today’s analysis my eyes alight on this bit.

On average, the non -regulated price components, most importantly the wholesale energy costs have a share of 40% -60% of the retail prices in the 10 selected Member States. Consequently,any impact of the oil price on wholesale prices only affects 40- 60% of the final consumer price (except for value added tax – VAT).

So the first round of price cuts should be for falls in pump and heating prices of around 50% of the fall in the Euro value of the oil price. As we stand that means a considerable boost to output and a bite-sized chunk out of consumer inflation. Less than an hour ago Eurostat told us this.

inflation is expected to be 0.3% in November 2014, down from 0.4% in October.

A 0% print would send the media into a deflation frenzy which would only be doubled if we got a negative consumer inflation print.

What about ECB Quantitative Easing?

I think that either of the two occurrences in the last sentence of the above paragraph would make it pretty much nailed on as a certainty. After all the ECB is an inflation targeting central bank and as i discussed yesterday it is currently claiming expansion whilst actually being in a holding pattern at best. If we factor in that the unemployment rate in Italy has hit a record (since 1977) of 13.2% this morning the pressure mounts.

Such expectations are now built into Euro area government bond yields where the German ten-year benchmark is at 0.7% and even more extraordinarily France is at 0.98%.

Comment

I have analysed one specific area today and we see that should things remain where they are measures of inflation have just been given a substantial downwards push. Ordinary people like you and I will welcome this as the prospect of cheaper goods and services comes into view. However central banks will not treat an undershoot of their inflation targets in the “same casual manner” to quote the television series Porridge as the Bank of England did with its overshoots. My suggestion that a Base Rate cut is as likely as a rise has been further reinforced by these events. The caveat comes from an economics paper written in 1976 by Rudiger Dornbusch about financial markets overshooting so let us wait and see what happens next.

How do I expect central banks to respond to this? Well I will leave that to the band Foreigner.

You say it’s urgent
Make it fast, make it urgent
Do it quick, do it urgent
Gotta rush, make it urgent
Want it quick
Urgent, urgent, emergency
Urgent, urgent, emergency

As to the falls in bond yields well as I look back through my career the words of Turkish in the film Snatch come to mind.

Who da thunk it?

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24 thoughts on “How much further have petrol and diesel prices to fall? And how will central banks respond to it?

  1. Great column, Shaun, as usual.

    At the press conference following the release of the November Inflation Report, Governor Carney was asked by Scott Hamilton: “Governor, you said more likely than not you’re going to have to write a letter to George Osborne explaining why inflation is one percentage point away from target. What are you going to say in that letter in terms of why the MPC is not taking action? Is it because, by saying it’s appropriate that markets are pushed back to their rate expectations, you’re happy for them to do the work for you?” He replied: Well, if you don’t mind, I’ll decide what I say in the letter, if I have to write the letter, because our forecast is for inflation not – I mean, our central expectation is that inflation dips around 1%, but doesn’t actually dip below, so strictly speaking, I do not expect to write the letter…” Maybe he is of a different opinion now.

    Now might be an opportune time for the Chancellor of the Exchequer to change the remit of the Bank of England so that the target rate is lower than 2% with a lower band below 1%. For now, that could be ¾%. It doesn’t seem to me that a dip in the inflation rate to 0.9% or 0.8% should be considered a cause for major concern. Those 1% to 3% bands were adopted on an indeterminate basis by the Bank of Canada in November 1993 before Gordon Brown decided to copy them in December 2003. Given the higher measurement bias in the Canadian CPI in the early 1990s as compared to the UK CPI, these bands really represented a looser monetary policy. Comparable bands would have been in the ¾% to 1¾% range, or lower. The formal adoption of the same target range as another central bank was not the same as the logical adoption of the same target range.

    With 2% inflation, the cost of living doubles every 35 years; with 1¾% inflation, it doubles every 40 years. The difference is not trivial.

    • Hi Andrew

      I can only agree as you are making a point I have argued since around 2002 when the UK switched from RPI-X to CPI inflation targeting. There was a relaxation of policy as the new target needed to be 1.75% rather than the 2%. That may not seem a big deal but of course we will never know now how much of a difference that would have made to pre credit crunch actions.

      As we stand the RPI-X to CPI gap has been widening and is currently 1.1% so the mere 0.5% change in target looks ever more of a relaxation of policy although of course there is an element of hindsight in that.

      We are seeing a concerted campaign to mislead people on the effects of low inflation right now and as ever it suits the banks….

  2. Hello Shaun ,

    As you are aware I am of the opinion that oil prices in the medium and certainly long term will actually increase. In saying that I do think we have broken or near broken the price lower level that LTO in North American can take before the LTO suppliers shut up shop and go bust

    In contrast to trying to stuff up Russia budget and punish Putin for his Ukraine adventures , I think the real danger lies in the fact that many LTO oil companies are know to be highly leaveraged .

    It is highly plausable that this “ponzi scheme” , as some in the American press put it , will collapse and the Banks and Corps who financed them will suffer “difficulties” like we saw from sub prime housing in 2008 .

    If this can be held off via more QE I think that will be done

    The short term effect of the stop market needs to be watched and like you with trade figures , I’d like to see this long term and the trend to continue , and the effects would be a stimulus but will it be enough ? 70$ still isn’t that cheap – how much supply will there be at 30$ ( and there’s then a host of other effects elsewhere!!) .

    I still suspect that supply is outstripping demand , not that a greater amount of oil is really being supplied but that the demand side is weak, the newer methods of GDP I think are covering up the issue of a weaker economy ( thus we welcome the lower price to boost the economy – which leads to s higher price that then tanks the economy – this is not the expected behaviour of a well supplied market )

    If the CB jump too soon and pump up the QE button now – then what will they do if the Banks then have another run ?

    Pump up the Volume again – MARRS ???

    Interesting times indeed

    forbin

    • Hi Forbin

      I agree that there is an underlying factor which is that we are using up a finite resource. Other players may help such as solar or nuclear but in essence we are likely to be consumers of carbon products for a while yet. On that trajectory peak oil will have other better days.

      However if we look at the present yesterday’s oil trading pattern of a bounce-back then a further drop looks poor as a pattern. So whilst we will no doubt see volatility lower prices than we have become used to seem set to be around.

      I too fear a bailout of the leveraged oil deals which may yet come under the QE banner. What ever happened to allowing risky trades to be risky?!

      As to the central banks unless it finds a new plan the ECB seems to have pretty much endgamed itself on the subject of QE. Otherwise the Italian bond market is at completely the wrong price (10 year yield 2.03%).

  3. How much of the general drop off in commodities prices is due to the Investment banks exiting the commodities business due to it being very expensive to finance now the regulatory capital rules have changed.

    • Hi Bootsy and welcome to my corner of the blogosphere

      I think that the bank trading desks definitely contributed to commodity price volatility and in the credit crunch years this was mostly upwards.The long rally from 2009 to 2011 where the CRB index nearly doubled looks dubious in hindsight. Of course there were other factors and correlation does not prove causation but they pull out and we see dips in commodity prices and quite a fall in the oil price.

  4. Shaun,

    Next OPEC meeting not until mid 2015 so output fixed in shortterm?
    Once US supplies squeezed then price rise in 2016 just when CBs achieved their inflation targets and beyond! Interesting times as always.

  5. Hi Shaun Thanks for another week of great blogging,I learnt more about the policies of the UKIP than I have done from all of the media. Perhaps I am reading the wrong newspapers. The fall in oil has swift and dramatic.It should give the world’s economy a great lift.However, with rate rises looking even further away some asset prices will become even more overpriced.
    As you have said consumers should have more money in there pockets and this should give the retail shops and online sellers a boost,But there will be many losers especially the Candanian extractors of oil from tar sands.Many countries need higher oil prices to pay their fiscal deficits especially Nigeria. I wonder if the UK fiscal deficit will take a hit from less tax take from the petrel pumps?

    • Hi Midge and thank you

      The OBR analysis I quoted suggested that an oil price fall would be good for the UK economy but neutral for the public finances. In essence the fall in oil based revenues would impact initially but then be offset by revenues from the economic improvement. There were a few caveats and assumptions in there so we will have to see how this plays out in practice.

      I agree that there will be shifts within the world economy and with Iron Ore prices weak and Dr Copper below US $3 there will be a shift from commodity producers and consumers. In terms of countries I also think of Ghana which I analysed earlier this year as it has great hopes for its oil discoveries/reserves.

  6. Hi Shaun
    What most forget is that US shale gas/oil is almost exclusively consumed in the US. WTI is always lower than Brent. There is absolutely nothing to stop Brent falling to $40/barrel or even lower. There is no shortage of the stuff, demand is falling. It won’t stay there of course but the idea that it will ‘always’ be over $100/barrel is and always was silly.
    I have often commented on UK Energy policy over the last 30 years, especially electricity. I commend the report linked below. It not completely accurate, but pretty close. The basis of ‘privatisation’ was ‘you cannot forecast energy or coomodity prices’ so don’t try to centrally plan.
    It was true then, its true now, shame no-one seems to listen.
    http://www.reform.co.uk/wp-content/uploads/2014/11/Energy-Report_text_AW_WEB1.pdf

    • Hi JW

      It’s Forbin’s point that we forget now the days of US $10 oil which were not that long ago. I think that the ending of the banks commodities desks has been a factor here and the Saudi’s are squeezing the competition. So we wait to see how far they will take this.

      I saw a rather amusing screenshot yesterday of an expert on CNBC predicting US $150 oil when it was US $106. On a Question of Sport they would ask what happened next?

      Unfortunately the message about central planning got misinterpreted as we are in fact getting “More,More,More” of it.

      Thanks for the link, I will take a look.

    • “There is absolutely nothing to stop Brent falling to $40/barrel or even lower” In fact there is – increasing demand as economies boom on cheaper energy. Most US oil is consumed in the US because of laws passed by Congress in the 70’s making illegal to export crude oil without a Government permit and they don’t give out many of those, although US refineries are allowed to export as much refined product as they want.

      As US has become more (but not completely) oil self sufficient this has impacted global demand for Brent whilst WTI trades lower thanks to the frackers, most of whom are probably struggling at these prices.

      • Hi Noo 2
        I don’t tend to respond to responses…
        Your first sentance describes the usual scenario of oil prices fluctuating wildly, between ‘too low’ and ‘too high’ , based on straight line forecasts ( which are never, ever right). Of course demand is stimulated at a price of $40, and then supply constrictions send it higher than $90. Doesn’t stop it going down to $40 though.
        Most US oil is consumed in the US and WTI is lower than Brent because of transportation constraints , more significant than legal issues which always can be overcome if expedient to do so.
        The US remains the biggest importer of crude in the world.
        If a company goes bust because it can’t pay its loans, doesn’t stop another taking over the assets at basement prices, and the oil continues to flow. The ‘fracked’ oil will flow as long as its available, some people might lose their shirts, but its now sunk costs. Its also become a national strategic asset for geo-political as well as economic reasons, it will be protected.

        • Thanks for the perspective. Time will tell which of us is right on $40, as I remain of the view that price won’t be achieved in the next 5 years.

        • In case you thought I believed in a “right price” for oil – I don’t in fact I don’t believe in a “rioght” price for any commodity or asset, there are simply affordable prices and unaffordable prices. When things get unaffordable they fall in price as we saw with oil in the cica $150 a barrel era.

        • I forgot- the US has some way to go to oil self sufficiency which may never happen, but it has made immense progress – 2010 imports 9,213000 barrels a day. 2012 imports 7,383000 barrels a day. The difference is equivalent to a reduction in export demand equivalent to approximately 3% of global production and it is that fall in imports which continues today to which I refer when saying global demand for Brent has been impacted, which, considering US GDP hasn’t managed to shrink during the period 2010 – 2012 is best explained by increasing oil self sufficiency.

    • Hi Dutch

      Well Russia faces issues for its public finances and its GDP and if we add in a Rouble rout where it nearly made 50 to the US Dollar on Friday it will also have inflation in a disinflationary world. I also think of Ghana as I have replied earlier with the IMF having issued a statement a month ago rather familiar to its “on track” days.

      “The authorities and the mission made significant progress towards reaching understandings on strengthened macroeconomic policies, including on a medium-term fiscal path consistent with ensuring debt sustainability and reducing the external current account deficit.”

      Not at US $70 per barrel for Brent Crude it isn’t.

  7. The idea that 15% off the cost of petrol, and even commensurate household energy price falls will be a magic wand to our economies is, in my view, somewhat optimistic.

    Lower commodity and and energy prices are helpful, sure, but they don’t fill people’s pockets to the same extent as they have been emptied.

    We have seen all the focus on wages, and the 10% that they have dropped, but that’s an average, and the fact that the lower down the scale you go the higher the loss, means that there is a greater advers effect on demand.

    No-one, however, seems to consider the absolute hammering that pensions have taken over the last decade.
    People who thought that they’d stay on final salary schemes, and reasonably wealthy in retirement, have been forced onto money-purchase schemes, and QE has helped to destroy the value of annuites.

    This, again in my view, does not just have a greater effect with the pensioners in an ageing demographic, it also curtails how generous they can be to both children and grandchildren, and I think we underestimate, or even ignore, what a large part of our economic activity is represented by those who no longer work.

    • Hi therrawbuzzin

      What the latest annual earnings data showed (ASHE) was that 70% of population have what we once regarded as normal i.e 4% annual wage growth. What this means is that 30% of the population are taking something of a pounding as you imply. The oil price falls will help everyone but as Orwell put it some will be more equal than others.

      The change for those with private pensions have been extraordinary and have led to the recent legislation changes as the web gets ever more tangled.

    • Hi the rawbuzzin and if I may develop one of your points a step further in relation to pensions. This does not bode well long term for economies with ageing populations as aggregate money will begin to fall as new pensioners realise their lower pensions and hence even lower growth/shrinkage is achieved.

  8. Shaun, thanks for alerting us to this critical commodity and its price fluctuation. My view is that US QE caused a great many asset and commodity bubbles from which the financial community and rich folk inevitably profited. I think this is one of those grey swan events. I’m not sure any central bank was sure about what would happen with QE other than it bought them time to maintain the status quo. When they got house price recovery, stocks bull market and commodity super cycle they thought brilliant, these are all “helpful” outcomes, more money has made us richer! :-/

    They hadn’t bargained that they would need to continuously feed all these “beasts” to maintain the party. Having stepped back or even just paused the QE we are seeing unsupported “false” markets. Just imagine if slowing commodities led to falling stock markets and…. worse.

    We need more QE NOW, only jesting but Im sure well get it.

    Paul C.

  9. Hi Shaun,

    And so we reach complete disagreement. It is my argument that if/when the ECB pushes the QE button this will act counter cyclically to the approaching EZ boom (if oil price stays where it is) via a falling Euro.I accept that initially it may strengthen as Bond investors pile into Euro sovereigns but the sheer volume of QE will over come this and the Euro will weaken about 6 months after QE commencement (along with falling Euro sovereign bond prices), hence creating the much sought after inflation and a nice check on a very likely overheating EZ economy. The reason this bizarre outcome will happen is because whilst parts of the global economy are starting to conform to the old textbooks, this particular scenario aint and we will see sovereign bonds and Euro equities move up together, folowed by standard textbook stuff of falling bonds and veer rising equities. This will be good for the EZ economy and for EZ equities if implemented intelligently.

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