West Texas Intermediate crude oil futures fell below $102 a barrel Wednesday, which represents a 22% drop over the past two weeks and meeting the technical definition of a bear market. It certainly doesn’t feel like a bear market, especially since crude is still up about 40% this year. And if you spend any time on Twitter, you know that oil and energy stocks have some very enthusiastic supporters, most of whom predict oil will rise to $200 a barrel. In fact, call options with a $200 strike price have traded rather briskly in recent weeks.
Most of the bull case in oil revolves around the twin theses of government incompetence and socially responsible, or ESG, investing, both of which are restricting drilling and raising the cost of capital for oil producers, thereby reducing supply. Now, the government is mulling a gasoline tax holiday and even issuing gas rebate cards, both of which represent a direct subsidy of demand. Every first-year economic student knows that if you increase the demand of a thing and reduce the supply of that thing, you are likely to increase the price of said thing. But that doesn’t explain the recent downturn in oil, and the oil bulls make no attempts at doing so.
So, what is the decline in oil prices all about? My guess is that it’s a reflection of the higher odds of a recession, and the resulting demand destruction. Oil tumbled as much as 8.24% on Wednesday, the most since early March, as Federal Reserve Chair Jerome Powell said a recession is possible and calling a soft landing “very challenging.” The drop in oil prices was accompanied by a big drop in bond yields. If the price of oil falls, so will inflation rates, as oil is a primary driver of inflation. And if that happens, the Fed won’t have to raise interest rates as much, resulting in lower bond yields. Stocks rallied as well, and the dollar weakened. The price of oil is driving all markets and the economy at the moment, and if oil prices go down, everything will get better.
It is likely that sentiment was getting a bit too hot in the energy markets. After all, the S&P 500 Integrated Oil & Gas Index was the top performing sector year-to-date, gaining almost 40% through Tuesday, compared with a 21% drop in the S&P 500. The question now is where does oil go from here? Does it return to an equilibrium level of $80 a barrel, or does it rocket to $200, like the macro doom crowd thinks? To be sure, the oil market is prone to wide swings. Crude fell 23% between March 8 and March 16, and 18% between March 23 and April 11, recovering with big rallies both times.
I tend to lean more toward the former. Gasoline is not an entirely inelastic commodity. If the price of it goes up enough, people will consume less. And that is what is happening. I recently drove from Ohio to South Carolina in a Mini Cooper, which gets about 42 miles per gallon, and still spent about $150 on gas. Someone in a Chevy Silverado would spend about three times that amount, which would put driving on par with flying in terms of cost. The price of gas had been so low for so long that people weren’t even thinking of it as a cost.
But there is demand elasticity, and when rising gas prices is accompanied by rising prices in food, electricity and other essentials, people will elect to drive less. As of April 2022, miles driven in the US measured on a rolling 12-month basis had mostly returned to the pre-pandemic highs, but I would not rule out a decline to the levels of the early 2010s when the economy was just emerging from the global financial crisis. Another thing to consider is that a measure of miles driven does not take into account the number of miles driven by electric vehicles, which is rising sharply. We are consuming even less gas than we think we are.
The anti-ESG trade is mostly played out at this point. For a while it became fashionable to buy the stocks that ESG indexes excluded. There was even an ETF launched on that basis. And the stocks that ESG excluded have vastly outperformed the ESG indexes. But I’d say we have reached peak moral panic about ESG. The cure for anything is too much of that thing. And if you believe that government incompetence is the primary driver of oil prices, don’t forget that there are the midterm elections coming in November, which are expected to be very lopsided against the current party in charge.
The only constant in financial markets is that when bullish or bearish sentiment becomes crowded, it is usually profitable to go the other way, which is what we are seeing in real time.
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