This is supposed to be the summer that the oil bull gets to finally stick it to the bear.
With demand back to pre-pandemic highs, a barrel is three times the July 2020 average of $40 and nearly 60% above year-ago levels.
Yet, the Federal Reserve is threatening to spoil the show for oil longs with the most draconian rate hike threats in a generation.
But it’s also an implied threat at the best, because the Fed itself isn’t issuing any dare against the oil market.
In fact, Chairman Jerome Powell—who vowed at the Fed’s just-concluded biannual testimony to the US Senate to do whatever it takes to tackle inflation— admitted that the central bank really can’t control some cost spikes. And that includes the most politically sensitive one: fuel prices at the pump.
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Powell said gasoline or grocery prices will not come down purely as a result of the Fed’s rate hikes. He explained that higher rates will dampen spending but not fix the insufficient supply of goods and commodities. One of the primary reasons for the 40-year highs in US inflation is that product/material availability severely lags demand.
“There’s really not anything that we can do about oil prices. They’re set at the global level.” Powell said in his testimony, lest some Senate members imagined him to be a financial version of the Disney pixie who, with a magical wave of its wand, could just wish away the current energy-generated inflation—which in May was estimated to be at nearly 35%, the most since Sept. 2005.
Even so, the near 14% plunge—at the time of writing—in crude prices over the past two weeks and the narrative spun around the sell-off suggests that the Fed’s rate hikes have everything to do with the recession fear building in the markets.
In Friday’s afternoon trading in Asia, US West Texas Intermediate crude hovered at under $104 a barrel, versus a three-month high of nearly $124 reached on June 14.
“A sustained break below $101 will support a further drop of $6 to $10 for WTI, bringing it toward the bears’ target of $98 to $95,” said Sunil Kumar Dixit, chief technical strategist at skcharting.com.
Talk is investors across markets are scared—not just scared, but petrified—about recession, or the “R-word”, as it has come to be known. In the case of oil, the Fed and its mantra of upcoming rate hikes are curbing the appetite of longs for higher prices while encouraging shorts to put on more bets for lower prices. These are indirectly achieving the Fed’s aim of cooling the energy component in inflation—despite Powell’s claims to the contrary.
But will such overtures last? The answer lies with the American consumer, who remains incredibly resilient in the face of the most incredible price pressures in a generation.
US household consumption accounts for around 68% of aggregate expenditure even after gross domestic product declined 1.4% in the first quarter. This is the kind of strength, economists say, could help GDP tread water and avoid a recession in 2022.
There are signs that consumer strength could be severely tested later this year, cautions Vivekanand Jayakumar, associate professor of economics at the University of Tampa.
“If household spending starts to buckle in the second half of 2022, the consequences for the broader economy will be enormous,” Jayakumar said in an op-ed that appeared earlier this month on The Hill, adding:
“In fact, if this most significant of all economic engines were to stall, the prospect for a US recession in 2023 will rise sharply.”
But demand for energy could be sticky by itself. Except for China which continues to fuss over domestic breakouts of COVID-19, the two-year-long coronavirus crisis, for all intent and purpose, is over for American consumers as well as people from leading OECD economies who are just bursting with wanderlust now after fatigue from the pandemic.
Gasoline stubbornly at around $5 a gallon hasn’t quite destroyed demand among US drivers in the run-up to the country’s peak summer season for road trips.
It’s the same story with air travel despite higher ticket prices for fliers and costlier jet fuel for carriers.
American consumers spent $6.6 billion in February booking airline tickets during the spring break, according to data compiled by Adobe Analytics. That was 6% higher than in February 2019, and up 18% from January of this year.
Through the first 15 days of May, spending by airlines rose 24% compared to 2019 while bookings were up only 3%. The gap between spending and bookings "highlights the effects of persistently high prices,” Adobe said.
AviationPros, an industry portal, said airlines were expected to consume 321 billion liters of fuel in 2022 compared with the 359 billion in 2019.
But while fuel will account for about a quarter of operating costs in 2022—at an estimated $192 billion—a particular feature of this year’s market was the high spread between crude and jet fuel prices, AviationPros noted.
“This jet crack spread remains well above historical norms, mostly owing to capacity constraints at refineries,” it said. “Under-investments in this area could mean that the spread remains elevated into 2023. At the same time, high oil and fuel prices are likely to see airlines improve their fuel efficiency—both through the use of more efficient aircraft and through operational decisions.”
On a broader level, supply shocks in the form of fresh emergency oil field outages or civil strife in producing countries could continue tipping the crude price game in OPEC’s favor.
The 13-member Saudi-led Organization of the Petroleum Exporting Countries has affirmed a production of 648,000 barrels daily for July and August—about 53% higher than in June. But OPEC and its 10 oil-producing allies—led by the heavily-sanctioned Russia—are adroit in bending the narrative in crude to their will, staying a step ahead of any market sell-off for the past 18 months. If anything, Europe’s continued mess in disentangling itself from Russian oil ensures continued support for crude at $100 a barrel.
So, with all these undercurrents in crude riding to favor longs in the market, will the Fed’s rate hikes make a material difference in lowering the price of a barrel?
Yes, provided that the central bank shocks with even larger hikes than imagined by forecasters. This month’s 75-basis point, or three-quarter point, rate increase, the biggest by the central bank in 28 years, was decided within days of the Consumer Price Index reaching a four-decade high of 8.6% reading in the year to May.
Some Fed bankers have advocated another 75-basis point hike for July. To send a truly deterrent message against pricing pressures, the central bank should probably do a 100-basis point, or full percentage point, in three of the four rate revisions it has left for the year. That will bring key lending rates to a high of 4.75% before the final December hike which could be 25 basis points to round up rates at 5%. The high for rates then will be 2-½ times above the Fed’s own 2% inflation target, accelerating its aim of achieving a so-called neutral for current inflation at above 8%.
With the 1.4% contraction in the first quarter, if the economy does not return to positive growth by the second quarter, it will technically be in a recession, given that it takes just two straight quarters of negative growth to make a recession.
The Fed has maintained that it has no intent in inducing a recession to achieve its aim of fighting inflation. Yet, the central bank may have little choice but to crash the US stock market (with a quarter or half of the job appearing to have been done), the housing market (which has barely slowed from the runaway growth of the past two years) and the jobs market (where wage growth remains rather resilient). Only then, will the selloff in oil likely stick, absent crude’s own demand destruction.
Disclaimer: Barani Krishnan uses a range of views outside his own to bring diversity to his analysis of any market. For neutrality, he sometimes presents contrarian views and market variables. He does not hold positions in the commodities and securities he writes about.