Oil, Recessions and the Hummer Comeback
It's been impossible to miss the headlines screaming about oil: Prices Plunge! Multiyear lows! Supply glut! Dollar rally!
My concern is less about a supply glut and more about falling demand. Despite a dearth of signals that a recession may be on its way, falling oil prices can be a sign that consumers are getting tired or are running out of discretionary income. In a post-credit-crisis recovery, where households have been deleveraging, this could have far-reaching ramifications.
We know that Europe's economy has slowed as austerity bites. Reduced spending by both households and governments is cutting energy consumption. Add to that slowing growth in China, which also is causing ripples through the rest of Asia, and you have the conditions for falling crude prices.
Declining demand puts pressure on prices, but what about supply -- how much is that driving prices lower?
Consider Saudi Arabia’s recent actions. Rather than defend prices by lowering production, it chose instead to cut prices last month. The Saudis appear to want to avoid repeating the mistakes of the 1980s. The strategy now seems to be to let prices fall to a level that might spark more consumption.
There's the rub: Oil prices have remained stubbornly high the past decade, causing a massive search for more oil, as well as its possible alternatives. The net result is a world awash in energy products: Shale oil and tar sands have added to the supplies of crude. Let’s also add that the U.S. automobile fleet is much more efficient. Fracking has created a huge supply of natural gas in North America, a cheap and cleaner alternative to oil, especially for home heating and electricity production. Add coal-based liquefied natural gas to the mix, and suddenly OPEC looks more vulnerable than it has in decades.
That is before we add in the strong U.S. dollar, now at a four-year high versus other currencies. Considering the one-two-three punch of increased supply hitting just as demand is faltering in the midst of a dollar rally, and it's no surprise that crude oil prices are down 22 percent since late June.
What might this mean for the broader economy? We never want to rely on just one variable when analyzing anything as complex as the global economic system; however, consider the following chart from FRED, the economic data library of the Federal Reserve Bank of St. Louis:
The chart shows that since the 1980s, oil prices tend to fall during a recession, not before. Indeed, we have seen spikes in oil prices, perhaps leading to the Federal Reserve to tighten and cause economic contractions. Regardless, in the past three decades, oil seems to be a coincidental, rather than leading indicator of future economic contractions.
That is the good news. The bad news is if you are an investor in energy you have seen asset prices drop significantly. Take the SPDR S&P Oil & Gas Exploration & Production ETF, for example, a popular exchange-traded fund. It topped out at $83.45 in June; yesterday’s close was $54.39, down about 35 percent. That takes it back to where it was in 2010.
Regardless of how energy-related equities trade, I keep coming back to what falling oil prices might mean for the consumer. The possibility of having a little extra jingle in the pocket could be a positive during the holiday shopping season.
Meantime, expect more volatility in energy prices. Who knows, maybe Hummer sales will pick up again.
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