This year we have seen inflation higher than it has been in 30 years. As I talk with clients, many think the high price of oil is the major driver of inflation. And there are concerns that the current administration’s energy policy is likely to make oil prices, and hence higher inflation, stay around for a number of years.
As I have outlined in clients meetings and various posts, it is likely that the higher inflation we are seeing comes mostly from temporary supply chain disruptions and the rising cost of labor as business look to expand and hire people when there are not enough qualified people looking for work. Yes, oil prices have a part in the one year inflation numbers, but this is nothing that we have not seen, even recently.
Oil prices vary based on supply and demand. When demand is low, prices go down, particularly when there is adequate supply. When supply is low and demand does not decrease, prices increase. This is what happened in the 1970s. At that point OPEC countries controlled most of the world’s oil supply, and as they cut supply, gas prices spiraled. But these countries do not monopolize oil production any more.
If you look at the chart below on the right below, you can see that current oil prices are much lower than they were from 2011 through 2014, are about what they were just three years ago, and not dramtically higher than they were before the pandemic. In those timeframes, inflation was much lower than it is today. So today’s oil prices are not the main driver of inflation.
The reason oil prices are higher is not mainly the Biden administration’s energy policy, but supply and demand. As you can see in the chart above on the right, the price of oil fell dramatically in March of 2020 as the world “stopped” because of COVID. Demand for oil was low as people were holed up in their homes and this pushed prices down. In today’s oil world, a lot of the resources are extracted out of the ground with technologies that are more expensive to use than the historical vertical oil drill. When prices dropped, these oil drillers stopped drilling as they could not make money at the then current low price. This led to supply decreasing, which which was okay until economies started to open up and demand began to rise. In the chart above on the left, look at the dip in production and consumption in 2020. But as economies opened and demand for oil started to steadily rise in the second half of 2020 and 2021, prices have increased due to higher demand and not enough supply because of the oil wells that were offline for months while the prices were too low for profitable drilling.
We expect that as prices continue to high enough for all oil drillers to be online, supply will eventually catch up with demand and oil prices will not continue to skyrocket. In fact, it is more likely that oil prices will drift lower over the coming years and be a detractor, not a contributor to inflation.