Oil prices jumped on Monday after some of the world’s biggest producers agreed to cut production. Here we explain what happened and what it might mean for inflation and interest rates.
Why are oil prices rising?
The reason oil prices jumped by more than 7% in early London trading was that members of the Opec+ cartel agreed a surprise cut in production over the weekend. The move, led by Saudi Arabia, will take effect next month and will reduce the supply of crude by more than 1m barrels a day. All other things being equal, limiting supply of oil leads to an increase in its price, and that explains why a barrel of Brent crude – one of the benchmarks for the market – hit nearly $86 a barrel.
Why has Opec+ taken this step?
This looks like a pre-emptive move from the cartel ahead of a likely economic slowdown – and possible recession in the US – later this year. Opec+ said its decision was aimed at ensuring stability in the oil market, by which it means putting a floor under oil prices of about $80 a barrel. Even so, the production cut represents a gamble that stronger demand from China – where the economy is recovering from its strict lockdown – will offset the dampening effect on demand in the west. It is a sign of the cooling of relations between Washington and Riyadh that the Saudis went ahead with their voluntary production cut despite strong opposition from Joe Biden’s administration.
Will higher prices stick?
This is the $64m dollar question. In the past, Opec+ has announced production cuts and then failed to follow through on the commitments. Traders will be looking closely for evidence of quota busting this time. But even if there is no cheating, today’s surge in the oil price to the highest level since January will only stick if the global economy can shrug off the impact of dearer energy. If it can’t, prices will come under downward pressure. Ipek Ozkardeskaya, senior analyst at Swissquote Bank, says it is possible “but hard” for oil prices to reach $100 a barrel, adding: “If the rising oil prices hit the global demand prospects at quite an uneasy time for the world economy (due to the bank stress) and further spurs recession worries, there is a chance that the rally in oil prices fades quickly.”
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What does this mean for inflation in the west?
The surprise move by Opec+ could scarcely have come at a worse time for the US, the UK and the EU – all of which are battling to reduce upward pressure on the cost of living. Although western economies are less oil-intensive than they were when Opec first became a household name 50 years ago, the cost of crude still matters. Higher oil prices make production and transport more expensive, and reduce the spending power of consumers. Central banks have been expecting inflation to fall sharply this year on the grounds that there will be no repeat of last year’s increase in energy costs triggered by Russia’s invasion of Ukraine. The Opec+ move threatens to make the fall in inflation a more protracted affair.
What does it mean for interest rates?
In theory, central banks should not respond immediately to a rise in oil prices and would only do so if there are knock-on effects – businesses raising their prices or offering more generous pay awards to their workers. In practice, higher oil prices at this juncture will almost certainly make the Federal Reserve, the Bank of England and the European Central Bank more cautious. If – and it remains a big if – Opec+ succeeds in permanently pushing up oil prices, the result will be that interest rates stay higher for longer. That will increase the risk of recession.
