The US Federal Reserve responds to the rise in oil prices

When the US Federal Reserve raised the federal funds target interest rate last week, by a quarter point to 3.75-4%, fuel prices were a key factor in the decision. “We cannot affect any individual price, whether it be oil prices, whether it be foodstuffs at the grocery store,” said Fed chairman Kevin Warsh after the decision was announced. “But what we can do, and will do, is ensure that any change in relative prices don't broaden out.”

The Fed sees the US economy as healthy, with GDP growth of about 2.3% this year and an unemployment rate of just 4.1%. In those conditions, businesses may try to protect their profits by passing increased fuel costs on to consumers in higher prices, pushing up inflation across the whole economy. That is what the Fed is trying to prevent.

Its analysis is a reminder that the full impact of the rise in oil prices this year has not yet been felt.

Some commentators have observed that the US and world economy have been remarkably resilient in the face of the surge in crude prices this year. Global growth remains generally stable, despite Brent rising from about US$60 a barrel at the beginning of January to about US$101 a barrel on Monday morning. But it is worth remembering that the economic impacts will continue to play out into next year and beyond.

The average retail price of gasoline in the US has risen to about US$4.48 a gallon, according to the American Automobile Association (AAA), up about 40% from its level a year ago.

The rise in diesel prices has been even sharper, with Russia’s ban on diesel exports contributing to the tightness of the global market. Diesel is currently retailing in the US at an average of about US$6.51 a gallon, up 76% over the past year.

A shutdown at ExxonMobil’s Joliet refinery in Illinois, originally triggered by a power outage, has added to the tightness of US diesel markets.

The US uses about 45 billion gallons of diesel for transport every year. If prices stay at these levels for a year, that represents an additional cost of about US$125 billion, or about 0.4% of US GDP. Sectors that are heavy users of diesel, including agriculture and fishing, are being hit particularly hard.

Calls for an urgent policy response are starting to emerge. Over the weekend Senator Chuck Grassley, a Republican who represents the agriculture-dependent state of Iowa, urged President Donald Trump to put an embargo on US diesel exports. He said high diesel prices were killing farmers’ income.

The pressures that have driven prices higher show no imminent signs of going into reverse. The conflict in the Middle East remains volatile. Mohammad Bagher Ghalibaf, the Speaker of the Iranian Parliament, said over the weekend that the country “must both fight and negotiate”, rather than opting for one or the other.

The US State Department on Saturday issued new advice to Americans, urging them to reconsider any plans to travel to or through the Middle East. It warned: “This military conflict has the potential to escalate rapidly.”

Meanwhile, Ukraine hit another Russian oil facility, targeting the Moscow Oil Refinery with drone strikes over the weekend. President Vladimir Putin of Russia has been reported as planning a further escalation of the war, including possible covert attacks in Europe.

The threat of intensifying conflict creates a tense and uncertain outlook for global energy.

The Wood Mackenzie view

If there is no agreement to resolve the conflict in the Middle East, oil prices are likely to continue to rise, Wood Mackenzie analysts say. Our Macro Oils team forecasts that the tightness of world markets will drive Brent crude to US$125 per barrel in October.

From an economic point of view, our primary concern is the vulnerability of investor sentiment and the artificial intelligence infrastructure boom in an environment of higher interest rates. Peter Martin, Wood Mackenzie’s head of economics, estimates that up to two-thirds of US GDP growth this year has been driven by AI-related capital spending. Broader domestic investment has remained lacklustre.

With short-term and long-term interest rates rising, and some leaders of the AI industry calling for a slowdown in the pace of development, that investment boom could start to deflate.

Widespread public resistance to data centre development could also be a factor in slowing the AI industry’s growth. The Financial Times reported over the weekend that about US$18 billion of loans tied to a data centre project in New Mexico, which is backed by Oracle, were trading at a significant discount to par value.

The project has faced strong local opposition, including challenges to the permits it needs to secure a natural gas pipeline to feed the fuel cells it will use as a power supply.

Wood Mackenzie’s Martin said an end to the AI investment boom, added to the squeeze on American consumers from higher fuel costs, could tip the US economy into recession.

Disruption to food production, caused by what could be a record-breaking El Niño weather event, could add to the pressures on the US and world economy.

With those threats looming, the US administration and Congress may be tempted to consider drastic measures, including the diesel export ban suggested by Senator Grassley. However, it is likely that such a move would be counter-productive.

Jamie Lewis, Wood Mackenzie’s principal analyst for US refining, said that if US refineries were forced to sell only to the domestic market, they would have to cut crude runs by about 4 million b/d. As a result, gasoline supply would be reduced by about 1.8 million b/d, forcing the US to import more and driving up prices for US consumers.

Although an export ban might seem superficially appealing, a real solution to the problems facing the US as a result of higher fuel prices can come only from addressing the wider issues in world markets.

In brief

Costco, the US retail chain, started limiting purchases of motor oil. Customers have been restricted to buying no more than 5 gallons per week of its Kirkland Signature synthetic motor oil. The move follows disruption to lubricants supply chains resulting from the conflict in the Middle East. The Pearl GTL complex in Qatar, which supplied base oil for premium lubricants, has been shut down since being hit by an Iranian strike in March.

Continental Resources, the privately held oil and gas producer, has become the latest US company to announce investments in Venezuela, although its path to production seems uncertain. It has agreed a Memorandum of Understanding with Venezuela's state oil company, PDVSA, to operate and develop the Ayacucho 2 Block in Venezuela's Orinoco Oil Belt. Wood Mackenzie analysis indicates that Ayacucho 2 holds 7.4 billion barrels of recoverable heavy oil, but none of the wells there are currently in production.

The move follows the announcement last month that Continental is adding to its position in Argentina, buying 50% of Phoenix Global Resources, an E&P company operating in the country’s Vaca Muerta shale formation. Continental will run the business as a 50/50 joint venture with commodity trading group Mercuria.

Google, Nvidia and Emerald AI have launched a new group, including 18 other energy and tech companies, to argue for policies that will help unlock the potential of flexible data centres. The group, called the AI Energy Management Alliance, will champion ideas for using flexible data centre loads as resources to support electricity grids. It aims to modernise grid planning and operations, to prioritise speed-to-power for AI data centres and accelerate innovation while protecting the interests of local communities.

Other views

Five market signals reshaping gas and power markets – Miaoru Huang and Allen Wang

Strong balance sheets set 2027 up for oil and gas portfolio renewal

After the strikes: what next for Qatar, Iran and the world's largest gas field?

New gas power policy of China’s Guangdong province drives structural shift from baseload to peak-only dispatch, resulting in reduced running hours

EU gas imports could reach 98% by 2050 without new field investment

Coal under pressure: navigating volatility in Australia's thermal coal market – Alex Griffiths, Natalie Biggs and Emily Brugge

The South Atlantic’s next exploration chapter – Fiona Piggott, Jessica Ciosek, and Alexander Connelly

Five things you need to know about the future of Asian refining – Alan Gelder, Jim Mitchell, Sushant Gupta and Kendrick Ng

Chevron plans drilling spree as it overhauls oil and gas search – Jamie Smyth and Michael Taffe

Quote of the week

“Bringing down fuel prices, providing relief for people, ending the price gouging at the pumps – that was precisely my priority, and we are achieving it with our agreement. Because for families, commuters, tradespeople, and everyone else who needs their car every day, these fuel prices are simply unaffordable.”

Lars Klingbeil, Germany’s finance minister, welcomed the relief package agreed by the country’s federal and state governments to ease the burden of higher fuel prices. The package includes cuts in federal and state taxes, as well as a commitment to talks with the oil industry about a proposed fuel price cap, to be introduced by the beginning of 2027.

Chart of the week

This comes from our new report: ‘Can gas grow its role in Indian power markets?’, by Wood Mackenzie’s analyst for Asia-Pacific power and renewables research, Nikhil Babu. It shows gas’s declining importance for India’s electricity system, in terms of capacity, on the left, and power generation, on the right.

Babu’s conclusion: “Gas-fired power is well positioned to support a renewables-led grid through peaking and flexibility services, but its commercial role will remain limited without improvements in fuel availability, market-based gas pricing and mechanisms that value system flexibility.” Read the full report for more details.

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