Given the relationship between climate policies, oil prices and inflation and the difficulties in managing inflation through interest rate policy, it is worth taking a closer look at the dynamics involved. [1] How might climate policies, oil prices and inflation evolve given the outlook for oil? To what extent are oil prices and consumer price inflation actually linked?
A brief history
In 1973, the Organization for Arab Petroleum Exporting Countries imposed an oil embargo on countries that had supported Israel during the Yom Kippur War, including the US. This was followed by US inflation (as measured by the consumer price index) rising by 14% year-on-year. This was replicated only six years later during the ‘second oil crisis’ when the oil price spiked in response to the Iranian Revolution and inflation tracked higher.
Exhibit 1: West Texas Intermediate crude oil prices (in USD) and US consumer prices – moving in tandem?
Source: FRED, BLS, BNP Paribas Asset Management analysis; Feb 2022
Policymakers beware. The last 12 months have seen the largest annualised increase in WTI crude oil since 1973. Annualised CPI is now hovering above 6%.
While a sustained increase in inflation wouldn’t be all bad, navigating a pathway through a long-term inflationary cycle could be challenging. This is because it may not be possible to use one of the main tools to combat inflation – central bank interest rate increases – at full strength in view of the heavy indebtedness of the public and private sectors in the US and elsewhere.
“While in the past energy prices often fell as quickly as they rose, the need to step up the fight against climate change may imply that fossil fuel prices will now not only have to stay elevated, but even have to keep rising if we are to meet the goals of the Paris climate agreement.”
Isabel Schnabel of the European Central Bank (ECB), January 2022 [2].
Oil is not the only commodity affecting inflation. The recent spike in natural gas prices in Europe has set off inflationary fears. [3] Additionally, as the transition to a low-carbon economy speeds up, we expect the prices of many key commodities used in low-carbon technology to increase.
To date, these prices have tended to be relatively disconnected from CPI, but as the use of low-carbon solutions becomes more prevalent, this could change. However, the focus of this article is on oil. This is meant to be illustrative rather than exclusive.
Supply and demand
While a wide variety of factors sway oil prices, we will examine a few key drivers with a climate-focused lens, in particular factors that could lead to an oil price (and inflation) spike (see table 1).
Table 1: A selection of climate-related oil price supply and demand factors
Source: BNP Paribas Asset Management
On the supply side, a variety of factors are now acting to diminish oil production including the precarious finances of many US shale oil producers, [4] growing investor pressure on publicly traded oil companies to adopt net zero (NZ) strategies [5] and increasingly stringent regulation. [6] Spare production capacity in OPEC countries, which is now quite high relative to recent history, [7] could alleviate any strains on production.
Indeed, the White House has called on OPEC to raise production. [8] This underscores the importance of OPEC and the lack of other policy tools available to the Biden administration to manage oil price-driven inflation in the short term. Longer term, it will be important for policymakers (and investors with exposure to inflation risk) to be mindful of the impact policy choices might have on oil markets.
One thing is clear: solving for oil-driven emissions will take more than just supply-side measures. Demand will need to decline or prices will rise significantly. If policymakers wish to avoid high inflation and/or draconian demand suppression techniques then they need to ensure that consumers of oil-based products such as petrol, jet fuel, propane and heating oil have ready access to alternatives – and fast.
Embedded – Oil is a pervasive factor
Another factor to be considered is the ‘embeddedness’ of oil prices in overall inflation. Conventional wisdom has it that oil is embedded in many of the products we buy every day, so inflation tracks its price closely. 2017 analysis by the Federal Reserve showed that the degree of oil price pass-through into overall inflation fell over time. [9]
However, a simpler analysis based just on the correlation of CPI changes with WTI changes indicates that the two still correlate with each other and perhaps even more now than before (see exhibit 2).
Nevertheless, oil is an important driver of inflation and a rapid decoupling of inflation from oil prices will likely be needed to insulate the economy from large inflationary spikes during the low-carbon transition.
Exhibit 2: Inflation and oil are interlinked – graph shows 12-month rolling correlation of YoY percentage change of CPI with 12-month percentage change of WTI prices in USD (monthly data)
Source: Bloomberg, BNP Paribas Asset Management.
One of the keys may well be to invest heavily in the electrification of transport and in non-fossil-fuel alternatives in other oil-dependent sectors such as power production. These two industries together account for around 40% of oil demand. [10] Getting the balance right will be a challenge, but doing nothing isn’t an option given the urgent need to mitigate climate change.
Opportunities and challenges for investors
For investors, tackling our dependence on oil comes with many risks. Companies in energy or energy-dependent sectors may see their value fall significantly or supply costs spike during the low-carbon transition.
And rate rises by central banks to combat inflation arising from inadvertent spikes in the oil price could cause large losses in equity and bond markets – or worse spark defaults leading to a credit-driven financial crisis.
Apart from managing such downside risks, we believe there is a clear upside as well. Trillions of dollars in capital will be needed to electrify the power and transport sectors over the coming decades [11] and more government support for this transition looks inevitable. [12] This creates opportunities in:
- Electricity grid modernisation and/or decentralised power production
- Metals and minerals production and recycling
- Electric or alternative fuel vehicle manufacturing
- Sustainable biofuels or hydrogen production and distribution
These dynamics are already unfolding in the markets as can be seen in exhibit 3: traditional energy (MSCI World Energy Sector index) has underperformed alternatives (MSCI Alternative Energy index). Not all low-carbon solutions providers have been winners; here active investment management is required. The performance of our energy transition strategy points to this potential.
Exhibit 3: A focus on sustainable energy transition is rewarded in the markets
*This refers to the performance of the BNP Paribas Energy Transition fund, which is mentioned for illustrative purposes only (1). Past performance is no guarantee of future performance. Source: MSCI, BNP Paribas Asset Management; Feb 2022
Supporting the low-carbon transition has never been more important as we work towards halving global carbon emissions by 2030 and towards net zero by 2050. Investing in low-carbon solutions companies can provide distinct alpha benefits; every additional dollar flowing into these areas also helps reduce beta risk from macroeconomic disruptions during the transition. The choice for investors is clear.
Notes and references
[1] ‘Greenflation’ in the title refers to a sharp rise in the price of materials, minerals, etc. that are used in the creation of renewable technologies. Source: https://www.collinsdictionary.com/submission/24485/greenflation#:~:text=greenflation-,New%20Word%20Suggestion,the%20creation%20of%20renewable%20technologies
[2] Greenflation Is a Crucial Step in the Energy Transition. Central Banks Take Note – Bloomberg
[3] What Wild Natural Gas Prices Mean for Inflation – WSJ
[4] U.S. oil producers on pace for most bankruptcies since last oil downturn | Reuters This article dates from the beginning of the coronavirus crisis
[7] Energy & Financial Markets – Crudeoil – U.S. Energy Information Administration (EIA)
[8] White House calls on OPEC to boost oil production as gas prices rise (cnbc.com)
[9] 2017085pap.pdf (federalreserve.gov) – page 13
[10] https://investors-corner.bnpparibas-am.com/investing/petrol-eroci-petroleum-age/
[12] What is the Inevitable Policy Response? | Thought Leadership | PRI (unpri.org)
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