From the Economist's Chair: USD strength may temper 2022’s more bullish outlooks

Author David Fyfe, Argus Chief Economist

Early-year bullish oil and commodity sentiment has been boosted by limited new restrictions due to Omicron and by supply-side tightness. Ongoing demand recovery seems assured for 2022, although a strong USD could place a cap over demand in key developing economies.

The new year has begun brightly for the commodity complex, with prices in the first 10 days of 2022 typically 5-6% up on where they ended 2021. In the last month, market focus on uncertainty about the new Omicron variant of Covid-19, its likely impact on oil demand and how this might change Opec+ policy towards supply increases, has dimmed.

More bullish oil supply outlooks, evidence of tight OECD oil stocks and comparatively limited government restrictions to address the Omicron threat have combined to paint a more constructive outlook for 2022. Of course, the mood music could change at any time, but chances appear good that global economic recovery will continue.

While that is encouraging for oil and commodity demand, recent crude price strength has arguably been driven more by inventory tightness and supply-side uncertainty. Those supply concerns have been intensified by a recent resurgence in ever-present geopolitical risks, with turmoil in Kazakhstan, a potential economic crisis brewing in Turkey, simmering border tensions in eastern Ukraine and seemingly stalled nuclear negotiations with Iran. With each being an important energy producer or transit state, instability has fed through to support prompt prices.

Nonetheless, it would be wrong to focus solely on geopolitics as this year's main "known unknown". Certainty about economic and financial market prospects in the year ahead also remains elusive, with distortions affecting everything from consumer spending, and retail and manufacturing costs to trade flows and labour markets. Question marks over 2022 have kept safe-haven gold supported near 1,800 dollars per ounce, even if it has weakened recently.

Oil demand has certainly benefitted from winter fuel switching as utilities and industry scramble to deal with spot gas in Europe and Asia still pricing stubbornly above $30/mmbtu. However, short-term headwinds and uncertainties for oil demand are also present. These include the disruptions those same energy price spikes are causing to industrial activity and consumer confidence, signs of Chinese economic growth slowing amid a real-estate sector liquidity crisis, the spectre of surging inflation and imminent interest rate increases, alongside a persistently strong US dollar.

The short-term relationship between the USD and crude prices is erratic. However, durable supply chain and labour market disruptions due to the pandemic have seen inflation expectations for 2022 ratcheted higher. Atlantic Basin Central Banks persist with a view that elevated inflation is likely to be a cyclical rather than a structural issue, but they are nonetheless generally beginning to tighten monetary policy to pre-empt spiralling wage and price increases. The Bank of England in December became the first among key central banks to start raising rates, and the US Federal Reserve could follow suit as early as March.

All else equal, higher US interest rates will be supportive of the US dollar. The impact on imported energy prices - largely denominated in dollar terms - is already being felt. USD crude costs, and those for imports to China and the EU in national currency terms, rose by around 35% between January to December 2021. But the corresponding rise for Indonesia, India, South Africa, Brazil and Japan was +40 to +50% due to the strengthening "Greenback". Meanwhile Turkey, pursuing a costly monetary policy experiment that seeks to cut interest rates in the face of soaring inflation, was paying 2.5 times more for crude in December than it did last January.

The USD Index is currently approaching its strongest level since before the pandemic and it will likely remain supported as the US Fed further unwinds stimulus and begins to raise interest rates through 2022. Commodity demand in the more indebted, developing economy importers will likely feel the pinch most from higher US interest rates and a stronger dollar. So, despite ongoing global recovery and what remains an imperfect feedback loop, dollar strength could act as a restraining influence on commodity demand and, ultimately, USD prices in the year ahead.

To receive this type of analysis more frequently, check out our Argus Crude and Refined Products Outlook. This monthly service pairs expert analysis on key market trends with forecast prices for key crude grades, regional benchmarks and oil products up to 24 months into the future.