Iran deal withdrawal may well hit you at the pump

Over the past few weeks, oil prices have rallied to levels not seen since November 2014. On Monday, West Texas Intermediate (WTI) crude oil prices surpassed $70 per barrel (pb) for the first time since 2014, while Brent crude traded above $75 pb.

Three factors have played a key role supporting higher energy prices: weaker supply, stronger demand and most importantly in recent days, geopolitical uncertainty surrounding the Iran sanctions.

As we look into the second half of 2018, what are the implications of higher oil prices for major economies throughout the world and what are the prospects for oil prices in the next few months?

Tighter supply and geopolitical uncertainty drive oil prices

The key driver of oil prices in recent days had been a growing belief that President Trump would reinstate sanctions on Iran, and exit the Joint Comprehensive Plan of Action (JCPOA) deal signed by the U.S., U.K., France, Germany, China and Russia in 2015.

With President Trump formally announcing the U.S. will exit the Iran nuclear deal, it appears likely there will be cutbacks in Iran oil production in the coming months. Importantly though, production is not expected to plunge given the inherent delays built into the deal — 90 days to 180 days before new sanctions fully take effect.

With Iran’s oil production up nearly 1 million barrels per day (mbpd) to 3.8 mbpd since the sanctions were lifted last year, there are concerns that reinstating sanctions on the fifth-largest oil producer in the world will curb global oil output by 300,000-600,000 barrels per day over the next year, creating further upward price pressures.

These concerns come as oil supply has tightened globally. Compliance to the promised OPEC oil production cuts has been remarkable with output down nearly 2 mbpd relative to 2016 levels.

Saudi Arabia, in particular, has shown an increased willingness to support higher oil prices even as some of the previously existing excess inventory has dissipated. Beyond OPEC compliance, the economic depression affecting Venezuela has also led to a severely curtailed oil output — production in the first quarter was down 25 percent, reaching 1.7 mbpd, its lowest level in 30 years.

Meanwhile, global oil demand remains strong despite a lackluster start to the year for Europe and the U.S. Solid activity in China and resilient momentum across most of Asia have maintained global demand for oil.

With demand still rising strongly — first-quarter growth was one of the strongest over the past decade — and production having tightened, oil stocks have fallen quite sharply, putting upward pressure on prices.

Higher oil price could dampen global momentum and shave half of the U.S. fiscal stimulus

If sustained, rising oil prices could sap global momentum. For oil-importing economies, higher energy prices typically translate into higher input and production costs, which, in turn, limit business activity and lead to higher inflation.

Simultaneously, higher prices at the pump and elevated inflation constrain households’ disposable income and outlays.

For the U.S. economy, a prolonged rise in oil prices could reverse part of the benefits from the fiscal stimulus. Oxford Economics estimates that the Tax Cuts and Jobs Act and the Bipartisan Budget Act will contribute 0.7 percentage points (ppt) to growth in 2018.

But if WTI crude prices average $70 pb this year, this could offset one-third to half of the fiscal boost in 2018.

Higher oil prices would also stimulate stronger investment in the shale oil sector, which in turn could offset some of the drag from reduced private-sector outlays. But the tremendous productivity improvements in the shale sector over the past four years would limit the offset.

Looking at the ratio of oil production to total rigs, it appears that productivity has doubled, if not tripled since 2014.

As such, while the 2014-2015 oil prices collapse (from over $100pb to $35pb) led to a significant 0.5 ppt drag on GDP growth from the energy sector (which represented only 1 percent of the economy), we should not expect anywhere near the same boost on the upside.

Globally, reduced activity for oil-importing countries would outweigh increased investment from oil-producing economies so that higher oil prices would have a constraining effect on global activity.

Oxford Economics finds that the most severe effect from an oil-price shock would be suffered by large emerging markets like China, India, Indonesia and Turkey.

Advanced economies with reduced oil-usage intensity would also suffer but to a lesser degree. Meanwhile, large oil exporters like Saudi Arabia and Russia would be the biggest “winners.”

Oil prices could trend lower absent geopolitical strains

Oxford Economics foresees the triad of moderate supply, solid demand and geopolitical uncertainty supporting higher oil prices in the short run. However, looking into the next few quarters, a number of factors could allow oil prices to fall back from their recent highs.

On the demand front, global growth appears to have peaked, and with global consumption and investment likely to moderate in the coming months, we could see reduced cost pressures.

On the supply front, increased U.S. supply as prices remain above break-even levels, and a relaxation of OPEC cuts — led by Saudi Arabia to avoid growth-deterring prices — could lead to a cooling of energy prices.

Finally, diminished geopolitical uncertainty would also dampen price pressures. Of course, we know that oil prices, as many commodities, tend to overshoot on the upside and downside due to investor positioning. As such, it would be foolish to discount further turbulence down the road.

Gregory Daco is the chief U.S. economist for Oxford Economics, a firm that provides research on major economies, the emerging markets, commodities, industrial sectors, global economics, global industry, cities and regions.