The Betting Line on Oil
Remember when oil prices went to negative $40/barrel in April 2020, and all market participants’ heads simultaneously exploded? Me too. Glad that’s over.
Except now we’re on the opposite end of the spectrum. How high is too high? Oil prices (Brent Crude) have climbed 34% since the beginning of Dec 2021 and topped $90/barrel for the first time since 2014. As a result, the Energy sector of the S&P 500 has seen a gain of 27% over the same period and an abundance of inflows as investors try to join the party.
Although prices still have a ways to go before they reach what I’d call “astronomical and concerning” levels, the swift move up and consensus call for even further upside makes me feel like we’re all sitting at a black jack table wanting the same card. But we can’t all have the card, and there’s always a chance the dealer wins.
Stay In or Cash Out?
Commodities markets are a tricky bunch. The swings in price can be head-snapping, inflection points can come so fast you miss them if you blink, and the forces that drive momentum shifts are often external, political, and completely unforecastable.
The risk-averse investor says, “too wild for my blood.” The speculator whispers, “this is my moment.”
The real question is, if we stay in because we believe prices will continue to rise, at what point do they go so far that they “break” demand? (See definition of price elasticity ). If there were a magic number that answered this question, I’d put it here. Unfortunately, there is no such thing. But there are historical reference points, as well as other metrics to watch in order to make our decisions.
Why does history matter? Because oftentimes, a spike in oil prices has been followed by a recession. Not because oil prices cause the recession, but because the spike is usually an outcome of excessive speculation, the consequence of a macro shock, or the result of outsized imbalances between supply and demand that proved to be a symptom of economic stress.
For example, from the beginning of 2008 to oil’s peak of $145.66/barrel on July 3, prices rose 53% before a precipitous decline of 77% to a bottom of $34.04/barrel on Dec 24, 2008. Talk about a wild swing.
How Can We Beat the Dealer?
I’d be lying if I said the run-up in oil prices doesn’t make me nervous. It does. But I also recognize that there is a chance the rise will simply coincide with inflation peaks and start to relax as we get through spring (watch: month-over-month CPI for a cooling off through Q1 and start of Q2). I do think there’s further upside in oil prices from here given the imminent end to winter (I think groundhogs make poor meteorologists) and an increase in business and leisure travel — including international travel (watch: TSA passenger numbers). Additionally, consumer demand for oil is relatively price inelastic (i.e., they’ll buy it anyway) compared to many other items (watch: consumer spending for signs of a slowdown).
But oil is an indicator not to be ignored. In coming weeks, I’ll be watching the $100/barrel threshold, which could cause market jitters if for nothing but psychological reasons. And if we blow through that $100 mark due to a geopolitical or macro shock, take it as a strong signal to dial down your portfolio risk. Oil prices alone do not predict economic fallout, but they are usually something we see in the rearview mirror and wish we’d paid attention to sooner.
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