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High Oil Prices and Recessions... Are we headed there?  Are you Prepared?

High Oil Prices and Recessions... Are we headed there? Are you Prepared?

March 11, 2022

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Last week we mentioned the risks from higher oil prices, and how it works as an additional tax on individuals and the economy.  With Gas now at well over $4.00 a gallon we’re taking a hard look at the chances this could push the US into a recession.   To be fair, it’s not just the Ukraine crisis, but also the global push toward greener energy that’s triggering the current spike in prices. 

It might surprise many of you that personal consumption accounts for about two-thirds of our economic activity.  Personal consumption means individuals buying everything from dishwashers, to clothes, to phones, all of which are made from petroleum.  In addition, gasoline is considered an inelastic good.  Regardless of how high the price, consumer demand doesn’t change much.  Given the difficulty in reducing gas usage, many consumers must spend less on other items or borrow to offset higher gas prices. Less spending means less economic activity.  Slow it down enough and you have a recession.  The following chart shows exactly that.  The grey bands are periods of recession and they almost perfectly match high oil spikes , Over this past 50 years, these two are highly correlated.   Please note that this chart is from Feb 28th.  Oil prices subsequently peaked at $123 on March 8th, putting us well above the risk threshold. 

 

Interestingly, as of today, the global oil output has NOT been disrupted.  The flow of oil from Russia has not yet been materially curtailed.  But a further ratcheting of sanctions, especially any directed specifically at their ability to sell oil, will push gas prices higher. The longer the conflict carries on and the more intense the fighting, the higher the likelihood that oil prices will stay elevated and possibly rise further, increasing the possibility of a recession. 

With much talk of increasing domestic oil production to help out, we instead see oil companies giving precious capital back to their shareholders and executives.  The same corporations paid their CEOs massive salary and compensation packages- most over $10 million, and as high as $33 million for Chevron CEO Michael Wirth.  At first blush, many are angry at such profit-motivated actions. However, put yourself in management’s shoes. Energy companies and their customers are increasingly under heat to reduce their carbon footprint. Assuming the push toward green energy continues, executives must carefully consider new long-lived projects, not only from an environmental perspective but from a profit perspective. Higher taxes on oil and oil exploration and increasing sources of green energy will potentially make future drilling less profitable. Unknowns such as these result in a lack of investment into the oil infrastructure.

To this end, U.S. oil rig counts have woefully kept up with prices as they have in the past. Based on the current oil price, we should see more than twice as many oil rigs in operation.

 

As if declining production and the Russian invasion of Ukraine weren’t enough of a problem, oil prices are also being boosted by rising demand. As the global economy normalizes from the pandemic, demand is steadily increasing.  It’s too early to say if higher oil prices and other economic factors will ultimately cause a recession. However, economic activity is already weak this quarter. The Atlanta Fed is now forecasting 0.0% GDP growth for the first quarter, and the effect of $4 or $5 gas has yet to factor into that forecast.  For the sake of full disclosure, other indicators are showing a low risk of a recession, but none we've seen so far are updated past February.    

So, are we headed toward a recession?  The jury is still out, but not looking good.  As mentioned above, the longer this all lasts, the greater the likelihood of a recession.  We will begin to get a better idea of how current gas prices are impacting consumption in mid-April when the next round of economic data is released. Until then, the big question is this.  If we are heading into are recession, are you prepared?  We are!  We've found that the only way to avoid the painful ride to the bottom is being willing to take demonstrative tactical moves, such as taking profits and increasing cash positions.  We are ready for that, are you?

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