Oil Creeps Back Above $100

OPEC+ might be cutting supply … different reads on the economy from oil traders and Wall Street … why investors fear Jackson Hole

Saudi Oil Minister Prince Abdulaziz bin Salman is not happy…

The result could be higher prices for you at the pump, as well as upward pressure on inflation.

We briefly touched on this story in yesterday’s Digest, but we should flesh it out in further detail because the potential ripple effects extend to your portfolio.

In short, bin Salman is frustrated with the disconnect between oil futures prices and the fundamentals of supply/demand in the global oil market. He sees futures prices as being too volatile relative to today’s actual market conditions.

Because of this, Bloomberg reports that he may push for OPEC+ to tighten oil production. And that would mean higher oil and gasoline prices for you and me.

Now, hidden in all of this is a more interesting inconsistency between oil traders and Wall Street. We’ll get to that in a moment.

First, let’s back up and fill in some details.

When it comes to oil, there are two prices

There’s the spot price, which is the current price in the marketplace, and then there are futures prices, which is simply a guess traders make at where prices will be at some stated point in the future.

Companies that are heavily dependent on oil often use the futures market to hedge their oil expense.

For instance, one of the biggest line items for airlines is fuel cost. But fuel prices are incredibly volatile, so buying on the open market could be disastrous if prices spike. So, airlines buy and sell crude oil futures as a way to hedge their actual fuel costs.

So, what’s the problem today?

From Bloomberg:

…Open interest and trading volumes [in futures prices] remain well below historical levels as the price swings caused by the war in Ukraine scare investors away.

The lack of trading is making the market more volatile as the pool of active buyers and sellers shrinks, according to some market participants.

Here’s bin Salman in an interview with Bloomberg with more on the impact of this:

The paper oil market has fallen into a self-perpetuating vicious circle of very thin liquidity and extreme volatility undermining the market’s essential function of efficient price discovery, and have made the cost of hedging and managing risks for physical users prohibitive…

This vicious circle is amplified by the flow of unsubstantiated stories about demand destruction, recurring news about the return of large volumes of supply, and ambiguity and uncertainty about the potential impacts of price caps, embargoes, and sanctions.

Given this, the Saudi Oil Minister appears to have had enough.

Here’s his not-so-subtle threat to the market:

OPEC+ has the commitment, the flexibility, and the means within the existing mechanisms of the Declaration of Cooperation to deal with such challenges and provide guidance including cutting production at any time and in different forms as has been clearly and repeatedly demonstrated in 2020 and 2021.

There are two aspects of this to watch as they both impact your wealth

First, there’s the immediate, obvious implication – bin Salman might push OPEC+ to cut oil production.

While the stated purpose is to reduce volatility in the futures market, it could also push your gas and home cooling costs materially higher at a time when household budgets are already stretched.

The second aspect of this is more interesting. It impacts your portfolio, and highlights the uncertainty of today’s investment markets.

The Saudi Oil Minister’s real problem here is probably not so much “volatility” and more “falling oil prices.” Between early-June and last week, the price of Brent Crude collapsed 25%.

Why?

The biggest reason is fear that we’re headed into a global recession that will kneecap demand for oil.

Here’s how MarketWatch recently described it:

[Some traders] believe that the energy and food crisis has been resolved and this is behind us, and nobody believes that prices are going to go up again because there’s a likely recession occurring and “history says you don’t want to be long commodities during [a] recession.”

And here’s CNBC:

Crude prices have been under pressure for weeks as fears mounted that a recession could cut oil demand.

So, oil traders have been pricing in a coming global recession – and they’ve been doing this since early June.

But what’s been happening over in the stock market since early June?

Despite weakness over the last few trading sessions, stocks have exploded higher.

And why, exactly?

From CNBC from a few weeks ago, when the market was in the midst of its bullish surge:

U.S. equities rallied Thursday for the second day in a row even after the latest GDP showed a second-straight contraction…

…investors shook off fears that the Federal Reserve’s attempts to tame surging prices would push the economy into a recession.

So, while oil futures traders have been pricing in a recession, Wall Street has been pricing in a non-recession.

Who’s right? And what will it mean?

Well, if oil future traders are right, we fall into a global recession. Oil prices keep falling, which helps take pressure off inflation and eases budgetary pain for millions of Americans.

Of course, a global recession will likely result in layoffs, bankruptcies, foreclosures, and more pain in the stock market.

On the other hand, if Wall Street is right and we avoid a global recession, that suggests oil prices may not be reflecting the robust demand of a world economy that’s still healthy (and without Russian oil).

That points toward upward pressure on oil prices…and by extension, higher prices for consumers and lingering inflation. Don’t forget, the big reduction in the recent Consumer Price Index report was almost 100% attributable to lower gas prices.

Is there no other option here?

Well, sure, there’s the proverbial “soft landing.” Everyone wants this, but history shows it’s hard to come by.

And what would that really look like, at least from an oil perspective?

With Russian oil being shunned, basic supply-demand economics suggests we’re not going back to $60 oil anytime soon without a recession. So, would oil prices just hover where they are today?

If so, what would that mean for the average U.S. consumer?

Yes, gasoline prices are down from $5.01 a gallon to roughly $3.86 a gallon, but $3.86 is still more than $1 above average prices before the pandemic.

To what extent would such a “new normal” price erode the health of consumer budgets and oil-intensive businesses over time?

So, what’s going to win out?

If you’re tempted to say “inflation data will decide” you’re partially right.

The answer is a tweak of that to “the Fed’s reaction to inflation data will decide.”

In Monday’s Digest, we looked at the mindset behind why the Fed might go easy on rate hikes in September, followed by a complete pause afterward.

In short, it boiled down to wanting to avoid a recession.

But we’ve also profiled the counter to that in the Digest.

It goes something along the lines of: With egg on its face from “transitory inflation,” the Fed is dead-set on stamping out inflation to prevent a repeat of the late 1970s. If a recession is needed to achieve this, so be it.

So, back to oil traders versus Wall Street, how are things shaping up?

Given the bearish performance of the stock market during recent trading sessions, it looks like Wall Street is blinking first.

From the end of last week through earlier this week, the S&P lost about 4% as jittery traders began to fear the Fed is willing to sacrifice the economy to end inflation.

Perhaps these traders stumbled upon this nugget from the minutes of the Fed’s July meeting released last Wednesday:

[Fed officials] recognized that policy firming could slow the pace of economic growth, but they saw the return of inflation to 2% as critical to achieving maximum employment on a sustained basis.”

So, oil traders or Wall Street… Who has been positioning correctly over the last two months?

All ears will be listening to what Powell says (and doesn’t say) for clues this Friday. We’ll keep you updated.

Have a good evening,

Jeff Remsburg

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