Mark Fowler: Oil price headwind for inflation

Oil is now about US$46 a barrel, an almost 15 per cent price drop for the year to date. Photo / Bloomberg

By Mark Fowler

Volatility across financial markets has been remarkably stable when we consider the number of political events, and risks, that have been evident this year.

However, this low volatility environment has served to mask a significant decrease in commodity prices - most notably oil, which is now about US$46 a barrel, marking an almost 15 per cent price drop for the year to date.

This latest slide in oil prices, if sustained, will continue to act as a significant headwind for global inflation.

There appear to be a number of factors contributing to the current oil glut, most of which can be attributed to a supply side imbalance. Many market analysts subscribe to the theory that there will be too much oil being produced, loaded, and marketed around the world until 2020.

Oil-driven destocking will continue to flood the market, exacerbating weakness in grades, structure and price. Even with rapid deceleration, US production next year is projected to be 1.2 million barrels per day above 2017 production.

This increase in US supply more than offsets the recent reductions from the Organisation of Petroleum Exporting Countries (Opec) leaving them with few options to address the supply side imbalance.

Central banks globally have long been lamenting the ramp up in asset inflation (namely housing) against a backdrop of weak underlying inflation (impacting wage growth).

A lower oil price has made the prospect of raising interest rates increasingly difficult, which is having an effect on long-dated bond yields.

US 10-year Treasuries yields - widely considered as a global benchmark to measure long-dated interest rates - are now trading at 2.15 per cent, having been as high as 2.60 per cent post the US elections.

The Reserve Bank of New Zealand (RBNZ) left the official cash rate unchanged last month, for the fourth consecutive meeting, citing the fact that "headline inflation has increased over the past year in several countries, but moderated recently with the fall in energy prices.

Core inflation and long-term bond yields remain low." This is a consistent theme across other developed countries, but is unlikely to assist in lowering the New Zealand dollar, as our growth trajectory continues to make New Zealand an attractive option for investors.

The continued higher dollar and lower cost at the pump will no doubt prove problematic in achieving the RBNZ's stated objective of returning to 2 per cent annualised inflation.

Oil prices have not fallen this much in any June month since 1988, when an eight-year war between Iran and Iraq, as key producers, was in its final stages. Tensions are once again rising in the Gulf with the Qatar embargo, but markets are paying little notice as they contend with brimming inventories and expanding US production.

• Mark Fowler is head of fixed income at Hobson Wealth Partners.

This article does not consider the objectives or situation of any particular investor. It should not be construed as a solicitation to buy or sell any security or product, or to engage in or refrain from engaging in any transaction.