"Brent crude oil was trading at USD27.88 a barrel (EUR25.52), the lowest price this year. Prices recently rebounded to USD50 (EUR44.70). Without trying to forecast future oil pricing trends – which, as shown by the experience of 2015, are even more difficult to predict than other economic variables – it is worthwhile to consider the consequences of higher prices.
So far, investors have welcomed this rebound. In the past, there has been a positive correlation between oil price fluctuations and equity market trends, a correlation that strengthens as oil prices decline. With the recent rebound in oil prices, this correlation is still positive, which illustrates the equity market’s enormous reactivity. Higher prices reflect not only renewed interest in the energy sector, but also a more general reassessment of the economic prospects of the oil producing countries: the rise in oil prices reduces the probability of several extremely negative scenarios, which could have had contagion effects on other countries.
Considering the substantial rebound from the low point in January, there is room to wonder when this sentiment will change, given the analyses highlighting the negative aspects of higher oil prices. A correlation analysis of oil and equity prices shows that when oil prices exceed USD75 a barrel, the correlation becomes random: it is nearly as often positive as negative. Let us be clear: in the current environment, this price seems unrealistic, if for no other reason than that it would trigger a significant increase in oil supply from fracking in the United States, which would likely cap the upturn in oil prices. Even so, the dynamics of the correlation reminds us that any future increases in black gold prices would give rise to less favourable alternative analyses.
One factor is its impact on inflation and central bank policies. In the eurozone, we estimate that for each USD10 increase in oil prices, headline inflation increases by about 0.4 percentage points. With the price increase already observed this year, we could see inflation expectations level off, renewed debate about its eventual impact on core inflation (which a priori should be very small), and even the feeling that the ECB might be tempted not to consider further additional measures. The anticipation of a monetary status quo might push up long-term rates and trigger a rise in the euro, all other factors remaining the same.
Given recent oil price trends, a net increase in headline inflation seems inevitable. In the eurozone, we are looking for headline inflation (including energy prices) of 0% in 2016, followed by 1.3% in 2017. For core inflation, our estimates are 0.8% and 0.9%, respectively. Even with the ongoing improvements in the job market, wage increases should fall short of headline inflation. Consequently, real wage growth will not be as strong as in 2015 and 2016, when it was buoyed by low oil prices. This also implies weaker growth and consumer spending. In addition to this headwind, we must also add the impact of the price increase on oil imports (increase in value) and consequently on the trade balance. All this should lead to somewhat slower growth.
In conclusion, although we welcome the rebound in oil prices because it rules out tail risk scenarios, we must keep in mind that there is indeed a reverse side to the coin."
William De Vijlder
Group Chief Economist, BNP Paribas
