To say that September was a disappointing month for crude oil would be an understatement. A growing chorus of economists singing about growth woes fueled expectations that demand for energy would weaken. Yet, just when bulls were ready to throw in the towel, events in the Middle East have once again prompted concerns over production in the region and how higher prices might spill over into not only the global economy, but even the U.S. presidential election.

Less than four weeks ago, West Texas Intermediate (WTI) futures had fallen to below US$66/barrel to the lowest level that we’ve seen since November 2021. Except for nine weeks since that low, WTI had traded above $70 prior to September, so the persistent weakness into the early part of last month led to a much more bearish tilt in market sentiment. And then two things happened – the Fed cut interest rates more than expected and tensions in the Middle East started to escalate again.

As the above chart shows, oil prices have experienced significant volatility in recent weeks due to a combination of geopolitical tensions, changes in supply, and fluctuations in global demand. In early October 2024, prices saw a sharp rise as conflicts in the Middle East intensified. Tensions between Israel and Iran, along with attacks by Iran-backed Houthi forces on vessels in the Red Sea, raised concerns about potential disruptions to oil supplies from the region.  In particular, in response to the missile attacks on Israel by Iran, there was heightened speculation that Israel might retaliate by targeting Iran’s oil infrastructure. 

As markets reacted to these escalating threats to supply, crude prices jumped and on Thursday, WTI and Brent futures had jumped by almost 5%. In the email notification for this week’s newsletter, we attached a report from our CIBC Asset Management team, entitled “Conflict Between Iran and Israel Continues” (if you would like to be added to our newsletter and media notification list, please click here). 

This situation is clearly very fluid and the potential disruptions to supply go beyond just Iran. Market participants are also concerned that this could spillover into other parts of the region, including the possibility that Iran might block the Strait of Hormuz or attack on Saudi Arabia’s own oil infrastructure. The threats to oil supplies from the region notwithstanding, the spike in prices has also been tempered by other factors.

The US is an important consideration here, since it is now the world’s largest exporters of oil – something we couldn’t say decades ago during similar crises. As the above chart shows, even taking data from 2022, the U.S. represented more than 20% of total world production, compared with 11% for Saudi Arabia and 10% for Russia. Iran’s share of production that year was under 4%.

China’s economy, a key driver of global oil consumption, continues to show signs of weakness, with manufacturing output shrinking for the fifth consecutive month. Despite efforts by Beijing to stimulate the economy, these measures have so far failed to significantly boost demand. At the same time, OPEC+ announced plans to increase production by 180,000 barrels per day starting in December, while the US reported a crude oil inventory increase of 3.9 million barrels.

One of the major downward pressures has come from the stronger U.S. dollar, which has made oil more expensive for countries using other currencies. After watching the market pumped on the notion of further aggressive Fed rate cuts, Chair Powell poured water on that idea earlier this week, suggesting that Fed officials are not as ready to go full dovish as some thought. This, along with some decent labour market data, helped push the US dollar higher.  This morning, economist predictions for the September payrolls report were blown out of the water, as the headline increase came in at 254,000 and the unemployment rate dipped to 4.1%.

As the above chart shows, the U.S. dollar index (DXY) has improved by close to 2% since late-September and is back to levels seen around the middle of August, as the above chart shows. These recent gains have come from what we call safe-haven flows, as investors react to geopolitical uncertainty by seeking out the most liquid and safest assets. Even though the U.S. has an appalling fiscal sheet, it is still a safe haven.

A longer-term examination highlights that the greenback is still trading well above its average over the past 20 years. This is keeping a lid on where oil prices can go, and therefore limits its influence on general consumer and producer price inflation. Our view is still that the dollar will experience a cyclical depreciation over the medium term as the Fed lowers rates, but for now  it is providing a cap on the potential inflationary influence from higher oil prices. 

The path that this conflict takes over the coming weeks, or months, will impact everything from economic growth and inflation to monetary policy. In other words, the outlook for bonds and equities hangs in the balance. The same week that we watched the Middle East crisis lurch towards an even more worrisome level, we had to contend with the prospect of a prolonged port strike in the U.S. This could have led to shortages and higher prices for many products, potentially causing a shift away from the prevailing view that disinflation is here to stay. Fortunately, that strike has been postponed until at least January. But investors need to look at the big picture.

Coming out of the pandemic, fiscal and monetary policy turned a recovery into a state of excess demand. That and the Ukraine invasion fueled an inflation flare-up. Today, economic growth is slower, inflation is falling and monetary policy remains restrictive, even though it is becoming looser, so there is not the same potential for supply disruptions in things like oil to re-create those inflation levels of 2022. That said, the situation is fluid and we will need to shift our tactical portfolio stance based on how the coming weeks unfold.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle