Understanding rising fuel prices

5 min read 17 Aug 22

Summary: Why do fuel prices fluctuate so much and what impact does it have on businesses and the economy? We look at the interplay of these factors and how moving to a more sustainable economy can help mitigate the effects of rising energy prices.

Why are fuel prices so high?

You will have noticed it at the pumps: prices have risen sharply over the past six months, with fuel prices in the UK reaching a record high in July. But what are the reasons behind this sudden spike? There are several factors at play. During the worldwide lockdowns in 2020 demand for fuel fell sharply, leading to a fall in oil prices. However, as countries and economies opened up, demand suddenly spiked. OPEC (The Organisation of the Petroleum Exporting Countries) had limited the amounts stockpiled and this sudden increase put pressure on oil supply, causing the cost of a barrel of oil to rise. The sanctions imposed on Russia as a result of its war on Ukraine, earlier in the year, only exacerbated this trend due to supply fears, as Russia is one of the top three oil producers in the world.  

Then there’s the effect of the US dollar exchange rate. The US is the largest producer and exporter of crude, meaning the pricing system is in US dollars. At the same time it’s also an overall net importer of crude oil, so rising oil prices are bad for the US economy, which in turn causes the US dollar to weaken. Hence there is usually an inverse relationship between the value of the dollar and the price of crude oil. 

The combination of these factors creates an environment of constantly changing prices. But this is only one element of what you pay at the pump. The UK Government also has an influence on fuel prices. A significant part of the price is taxes. Currently, fuel duty is 52.95p per litre for petrol and diesel, and then there is 20% of value added tax (VAT). All of this means that around half of the price we pay goes directly to the Treasury. And don’t forget, the retailer also needs to make a profit.

What effect does this have on the economy?

Oil accounts for 3% of the world GDP (gross domestic product). It’s one of the most important commodities and it’s a basic ingredient in a wide variety of products. If your base ingredient costs more to buy, your product will cost more to manufacture, as some of that cost gets passed onto the consumer. 

As consumer sentiment drops, businesses have to tighten their belts which can impact economic growth. As it’s hard to predict when oil prices might fall once again, this feeling of uncertainty pervades the economy. When the price of oil does eventually go down, unfortunately it will still take a while for this price drop to be passed on to businesses and consumers.

There are many other reasons why the increase in the oil price is driving inflation, besides just the cost of filling the tank going up. The most obvious is that the cost of shipping goods has gone up, and in our globalised economy that makes a significant impact on the cost of all sorts of things we buy. Then there are all the products which are made with derivatives of petroleum: anything made out of plastic, man-made clothing fibres, chemicals and fertilisers – so it impacts farming and food. It’s even used to make aspirin.  

Everything is also costing more, but salaries aren’t increasing at the same rate, so people cut back on discretionary spending. This can cause the economy to go into reverse. For example, fewer people eating out and going on holiday will lead to a reduction in staff in those industries, potentially increasing the unemployment rate if industries across the board are all feeling the squeeze. 

It may even have an effect on house prices, in two ways. First, if more of your money is going on essentials such as petrol and food, there is less available to spend on a mortgage, and this may in turn lead to house buyers driving a much harder bargain and starting to slow the growth in house prices. Secondly, with the central bank increasing interest rates to fight inflation, banks are already starting to raise the rates on mortgages on offer for house buyers, who therefore may not be able to afford to keep paying higher home prices. 

Are there any positives to high oil prices?

On the upside, the higher costs of fuel is driving more sustainable behaviours. People are driving less and changing their habits to get the most value out of their fuel – things like grouping errands, or shopping closer to home. Better car maintenance and good driving habits all help to make the fuel usage more efficient. 

People may also be more inclined to use public transport more now. And when it comes to buying a new car, people will be more motivated to look at cars that are cheaper to run and that means cars which pollute less, so this is where the hybrid car industry can benefit. Suddenly, the initial cost of an electric car seems less daunting as the benefits of cheaper running costs are much more apparent.  

This behaviour change creates a knock-on effect: as we look for sensible, viable alternatives to petrol, the industry and the demand for scientists and engineers in these fields expands. The more people we have looking for better and cleaner ways to use energy, the more likely we are to find sustainable and economically viable answers.

Please bear in mind that M&G Investments are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser. The views expressed here should not be taken as a recommendation, advice or forecast.

The value of any fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

By M&G Investments

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