Oil prices are falling – what does this mean for the cost of living crisis?

Start with a question. Is the global oil price higher now than it was when Russia invaded Ukraine? Higher, surely – isn’t that why our fuel bills are soaring? Well, the answer is that it is a tiny bit lower.

Brent crude is $94.66 a barrel now, whereas on 23 February it closed at $96.84. It could jump up tomorrow – and, thanks to the rise of the dollar, it is still higher in sterling or euro terms. That is part of the reason why we are still paying more to fill up our cars. But when you get a surprising market movement like this you have to ask why, and then think through what the markets might be trying to tell us.

The “why?” must start with the point that the market seems to be moving into a global surplus. Production, according to the International Energy Agency, is up a bit. Russia seems to be getting its oil out despite sanctions. The US is pumping as much as it can. And the Organisation of the Petroleum Exporting Countries (Opec) has just agreed to a small increase in output in September.

But the really big shift is not in supply, but in demand. In the West, any such falls were marginal. We all tried to economise a bit – fuel demand has gone down – but the surge in gas prices has meant that where possible oil is being used instead of gas, particularly in Germany.

The greatest change in demand has come from China. The economy there slowed sharply in the second quarter and seems to have headed on down in July, according to forecasters China Beige Book International. You don’t need to buy all the negative stories about China to conclude that the slowdown there is very real. If Chinese output is weak, it buys less oil –and, since it is the world’s largest oil importer, that has a dramatic impact on the price.

Depending on your expectations for China in the coming months, it is plausible that the oil price could head on down, back – who knows? – to the levels of a year ago, or less. Put round the other way, whatever happens to gas prices this winter, which is really a function of Russia’s decisions on exports to Europe, the oil price does not look like going back to the $120-a-barrel levels of a few weeks ago.

If this is right, what does it mean? There is a negative story and a positive one.

The negative story is that we might be running into a recession in much of the developed world. I don’t think there is much point in trying to add to the deadweight of gloom that has been washing over the UK, and indeed Europe and the US, in the past few days. But what is surely worth saying is that a recession is a sure-fire way of holding down energy demand – and hence the oil price.

The positive story is that a lower oil price will have a profound impact on inflation more generally. It isn’t easy to have much faith in official forecasts of inflation because the present lot have been so wrong. But outcomes can surprise on the other side. Some work by the London-based consultancy Longview Economics suggests that the mood of the whole oil market is shifting from lack of supply to lack of demand. It doesn’t make such a prediction, but it seems to me that if its demand/supply argument is right, the oil price could go back to the level of a year ago – around $70 a barrel.

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This does not mean that the whole cost of living crisis will be over. Europe made itself far too dependent on Russia’s gas. Disruption of supply chains will be here for months before they ease. Coping with the shortages of labour in many services, including the huge travel and tourist industries, will take months to solve and will continue to push up costs. But a lower oil price takes away one of the forces that has been driving inflation upwards.

See it this way. A number of things have to come together in the next few months before the world can dig itself out of the current terrifying inflation crisis. Food supplies have to be built up and, given the importance of Ukraine as a grain producer, that will be very difficult. Alternative sources of energy, including renewables, need to be developed and until that happens the world must learn to economise on energy.

But a sustained fall in the oil price would be the first building block in a return to normality. And that, fingers crossed, is what the world seems likely to get.