A reversal in oil prices and energy stock prices could begin. The reason for this is that oil price reversals are the inevitable result of economic recessions. Of course, this is due to previous price spikes that create demand destruction in the economy.
The graph shows the price of oil since 1946.
Rising oil prices benefit oil companies by making the extraction process more profitable. However, there is also a negative impact on the economy.
“High oil prices increase the costs of doing business which ultimately trickle down to customers and businesses. Whether it’s higher taxi fares, more expensive plane tickets, from the cost of apples shipped from California or new furniture shipped from China, high oil prices can lead to higher prices for seemingly unrelated products and services – Investopedia
Of course, consumers who fill up their gas tanks every week immediately notice high oil prices. While core inflation reports exclude food and energy, these items drive consumption patterns in the short term. Since consumption accounts for around 70% of the GDP calculation, the impact of rising oil prices is almost immediate.
As shown below, oil price spikes have a strong correlation with economic recessions, financial events, and oil price reversals.
The link with oil
Oil prices are crucial to the overall economic equation. As prices rise, this translates into higher inflationary costs for consumers. Unsurprisingly, there is a strong correlation between rising and falling energy prices and the consumer price index.
Oil prices impact virtually every aspect of our lives, from our food to the products and services we buy. Therefore, the demand side of the equation is a telltale sign of economic strength or weakness. As noted, oil prices follow our combined rates, inflation and GDP index.
Since the oil industry is very manufacturing and production intensive, rising oil prices increase manufacturing, investment spending and economic growth. It also works in reverse.
“It should come as no surprise that sharp spikes in oil prices have coincided with slowdowns in economic activity, falling inflation and a subsequent drop in interest rates.”
The most recent spike in oil prices resulted from the massive flooding of fiscal policy and a shortage of supply. In recent years, an aggressive policy and “green power” campaign by Wall Street has limited drilling and refining permits. These policies reduced capital formation for drilling projects and removed incentives for oil exploration.
While the shutdown of the economy due to the pandemic has created a shortage of supply, the influx of cash has inevitably created a surge in demand. This “forward push” in consumption led to rising inflationary pressures and higher oil prices. We show the strong correlation between oil prices and inflation breakevens.
The short version is that oil prices reflect supply and demand. With the inversion of liquidity, economic demand weakens as the cost of living exceeds real wages. As noted, the correlation between peak oil and declines in economic growth (3-year average growth rate) should come as no surprise.
Warning Signs of the Next Oil Price Reversal
While many analysts are talking about oil at $200/bbl, it is just as possible that oil prices will drop to $60. After all, not so long ago, oil prices turned negative for a short time.
With the US economy on the verge of recession as the Fed aggressively raises interest rates, the risk of a deflationary backdrop increases.
On the other hand, retail sales also present consumption problems. Retail sales are measured in “dollars” rather than “volume”. Thus, the most recent decline in retail sales has been a decline in volume purchased as prices rose.
Naturally, slowing economic growth and deflationary pressures will contribute to a reversal in oil prices as consumers choose to drive less.
As noted, as the Federal Reserve raises rates and shrinks its balance sheet, this extracts liquidity from speculative trading. This is why commodities, especially oil, tend to crash regularly.
Although the recent rally in energy stocks has been quite strong, we have probably reached the top. Aggressive rate hikes by the Fed have previously led to reversals in energy stocks and oil prices. As noted, commodity prices are a function of market speculation. Therefore, a liquidity inversion will have a negative impact.
Unfortunately, if history repeats itself, it won’t just be oil prices and energy stocks that will be reduced in the process.
The opinions expressed in this article are the opinions of the author and do not necessarily reflect the opinions of The Epoch Times.