The politics and policy of global inflation will begin to shape markets as major global economies push back in direct and indirect ways on the surging price of oil.
It would appear that the combined action is an attempt to keep oil prices below $80 per barrel, which may prove difficult.
Recent jawboning of the oil market by the Biden administration and its global allies has resulted in a roughly 9% decline in the price of the U.S. benchmark West Texas Intermediate since late October and a 6% decline in global benchmark Brent crude.
And now, major economies have taken action. For the second time in the past decade, there has been a coordinated release of the strategic petroleum reserves of major economies to directly push down the price of oil and indirectly the cost of gasoline during a time of rising global inflation.
The United States said on Tuesday that it would release 50 million barrels from its strategic reserves—32 million over the next several months and 18 million in an accelerated release from previously announced sales.
Other countries will participate in the coordinated release, including 5 million barrels by India, 7.3 million by China, 1.5 million by the U.K. and an unspecified quantity by both Japan and South Korea.
It would appear that the combined action is an attempt to keep oil prices below $80 per barrel, which may prove difficult given the lack of investment and production declines over the past few years.
Still, for these economies, the coordinated release is largely a risk-free action because they can sell oil at anywhere between $77 and $82 per barrel at current prices and replenish the stocks inside the strategic petroleum reserve by purchasing out along the curve where the cost is roughly $60 in 2026 contracts. This policy action can be effectively hedged by each domestic energy authority.
Further price declines will most likely come from a combination of public pressure by governments, risks in the oil and energy markets, possible increases in domestic U.S. shale production and the willingness of OPEC to follow through on its commitment to add 400,000 barrels per day to global supply in 2023. If these actions are successful, they will have a big effect on reducing inflation in the near to medium term.
But the actual probability of policy success is quite limited and these actions will have more to do with public and political optics. The policy and political logic here is that it is better to try to do something as opposed to achieve a discrete policy goal. That is because actual achievement through this policy path will almost certainly prove ephemeral.
That being said, the price of oil is determined in large part by speculative activity, or just oversimplified paper trading, and is only tangentially related to supply and demand dynamics in the market.
The paper market in oil is 30 to 50 times larger than the actual physical market, and this explains the action taken by the major economies. At the end of the day, it is the speculative channel where actions like the ones taken by the six major economies may work to the extent that they do.
The domestic oil market
The domestic oil and gasoline market has been in disarray for much of the past 10 years. This has to do with malinvestment in domestic production that resulted in a peak in tight oil production in 2013, well before anyone uttered the phrase ESG. But over the past two years, investment in the industry has been curtailed as discipline by financiers has returned to the market amid revived demand.
Production of shale oil and natural gas in the Permian region of Texas and New Mexico─which was drastically curtailed during the pandemic─is finally reaching pre-pandemic levels. According to the latest information from the U.S. Energy Information Administration, oil production rose by 67,000 barrels per day and natural gas production increased by a million cubic feet/day month over month. Estimates by Rystad put the monthly increase in total U.S. shale production at 76,000 per day, which is an 8% increase over last year.
Domestic gasoline prices
Gasoline prices in the U.S., which stand at $3.40 per gallon for regular, are up by 92% from their pandemic low of $1.77. A more useful comparison, however, might be that current gas prices are more than 30% higher than the rolling five-year average of $2.59 per gallon that prevailed before the pandemic.
Perhaps a better way to look at the price of gasoline is over a longer time frame and by adjusting for inflation. Using the rolling five-year benchmark, the 2015 consumer price index gasoline index of 288.5 shows a real gasoline price of roughly $2.96 per gallon, or up by 15.2%.
Tangible policy achievements will almost certainly prove short-lived given the relatively modest release into a global market largely dominated by the OPEC cartel.
On an inflation-adjusted basis, the cost of domestic gasoline has increased very little in the long-term. That will provide cold comfort for households still struggling in the aftermath of the pandemic and spending more of their fixed monthly costs on energy and transportation. That is why the six governments of the major economies sought to act in coordination.