The state of play with the energy price shock

Past energy supply shocks have seen central banks cut rates modestly as they balance higher inflation and higher unemployment, although at present interest rate markets are more worried about inflation. Shipping volumes through the Strait of Hormuz are still very low, where there is the risk that US and Israeli bombing damages Iranian oil production, which accounts for 5% of global output. Prices of key energy and industrial commodities have surged in line past supply shocks. Higher energy prices should be immediately reflected in higher headline inflation, with an additional boost likely from food prices. The impact on core inflation should be modest, unless inflation expectations increase, as happened in the 1970s, leading to much higher interest rates.

Depending on its duration, the current energy supply shock will be a drag on world output mainly from Q2 onwards via fuel shortages and higher prices curbing demand:

1. The greatly reduced supply of key commodities acts as a drag on production, especially for the transport sector, depending on the duration of the shock and when existing inventories are exhausted.
2. Higher prices effectively act as a more immediate “tax” on spending and investment unless governments cap prices and/or provide financial assistance to offset the cost.

Quantifying the first effect is very difficult because reliable world data on the production of energy are only made publicly available with a long lag, but fuel shortages are emerging in Asia, which is highly dependent on exports from the Gulf. In contrast, energy prices are readily observable, although widely-quoted futures prices understate the recent rise in spot prices.

Economies have become much more fuel efficient since the 1970s, but growth in world energy production is still correlated with growth in world GDP, and this shock is unusual in that the supply of a wide range of key commodities has been affected.

Note that in terms of the two effects, the US is an outlier among the advanced economies in that it is the world’s largest producer of oil, exporting the excess to the rest of the world, although US GDP is still affected by the second channel.  

The duration of the shock remains unknown, although equity prices appear to be factoring in a relatively short shock, while rates markets are more worried about the risks to inflation.

The latter is reflected in rates markets either pricing out expected rate cuts, switching from pricing in rate cuts to pricing in rate hikes, or, in the unique example of Australia, pricing in additional tightening.

Past energy shocks have usually seen central banks cut interest rates as the balance higher inflation and higher unemployment, although not by much. This time differs from earlier episodes in that interest rates are not at a high starting point and risks around inflation and inflation expectations are greater in that central banks have not returned inflation to target.

  

Notwithstanding the uncertainty about the duration of the shock, there has been some positive news about the supply of commodities from the Gulf, in that the number of ships exiting the Strait of Hormuz has picked up lately (Iran is permitting some ships to exit the Gulf, sometimes charging tolls). However, estimated shipping volumes are still very low.

In terms of risks to supply, the pace of recovery in shipping volumes will depend on whether Iran continues to restrict traffic, as well as the time it takes to repair damaged production facilities in the region. If Iran successfully imposes a toll on traffic, shipping volumes would presumably recover more quickly at a higher end-cost to the Gulf’s trading partners, most of whom are in Asia.

Also on risks to supply, if the US and Israel bomb Iranian infrastructure past Tuesday’s 8pm ET deadline, Iran’s oil production – which accounts for about 5% of world output – could be out of action for an extended period.  

As for key commodity prices, the increase over March and April to date has been:

• The world price of oil c.65%;
• The world price of gas c.30%;
• The US price of jet fuel c.95%;
• The benchmark Ukrainian price of urea, a key fertiliser c.75%;
• The benchmark Australian price of coal c.15%; and
• The US price of diesel c.35%.

As shown in the charts below, these massive price rises are similar to the increases seen in past oil price shocks in inflation-adjusted terms, except for thermal coal, which is not directly affected by the war, serving as a substitute in the generation of electricity.    

While energy prices have a large and immediate effect on headline inflation, subject to any government retail price caps/subsidies, the spike in fertiliser prices will have an additional impact on food prices, adding to the boost from higher transport costs and the effects of a potential El Nino.

Modelling shows that energy prices tend to have a small impact on core inflation, although central banks will be worried about the possibility that high headline inflation feeds into inflation expectations given the broad nature of this shock and with inflation yet to return to target on a sustainable basis.

Finally, it is worth remembering that futures prices – which are widely used to forecast commodity prices – unfortunately have a poor track record of prediction, even in normal times. The same holds true for surveys of commodity analysts and investors.