How to know when oil prices will cause a recession, and what to invest in
With the national average for a gallon of gas hitting its highest price since 2008 and the stock market on edge with the first land war in Europe since WWII being waged by one of the world’s biggest crude oil producers, crude oil prices and energy stocks are an area of focus for investors. It is hard for stock market participants to avoid the question, are energy stocks, which have had a huge run since the pandemic bottom, still a buy given the geopolitical premium? But the related question could stop them in their tracks before continuing: will oil prices cause a recession?
Bespoke noted last week that as of Friday morning, WTI crude oil was up just over 20% within the week, one of five periods where crude rallied more than 20% in a week. It noted that three of the prior four periods where prices spiked occurred during recessions.
Rystad Energy, one of the top global energy sector consulting and research firms, expects a plunge in Russian oil exports of as much as 1 million barrels per day — and limited Middle Eastern spare capacity to replace these supplies — to result in a net impact that oil prices are likely to continue to climb, potentially beyond $130 per barrel, and relief measures such as releases from the Strategic Petroleum Reserve can’t make up the difference.
There is of course disagreement and contrarian takes. Citi’s commodities team wrote last week it is becoming “probable” that oil prices have peaked already or could soon consolidate near a top. But that would require a de-escalation in the Russia invasion of Ukraine and progress on Iran talks. U.S. inventories are at or near lows, but Citi says stock builds are on the way in 2Q’22.
For Nicholas Colas, co-founder of DataTrek Research, this is a good time to look at the value of energy stocks in a diversified portfolio and how to think about the risk of oil prices causing a recession.
When the price of oil signals a recession and how close we are to it
As an analyst covering the auto sector earlier in his career, Colas remembers the presentation decks used by economists employed by the “Big Three” automakers three decades ago, which they had been using since the 1970s oil shocks.
“The rule of thumb I learned from auto industry economics in the 1990s is that if oil prices go up 100% in a one-year period, expect a recession,” he says.
A year ago, crude oil was $63.81 (March 4, 2021) a barrel. Double that and that is the strike price for a recession. Crude oil is currently at $115.
“We are close and getting there fast,” Colas said.
“We’re at the point now where prices at the pump are higher on the way home from work than on the way in,” Bespoke wrote in a note to clients on Friday.
But Colas added oil prices would need to be persistently over that doubling, staying at $130 rather than merely spiking and pulling back quickly, to be concerned. “A day or two is OK, but a few weeks is not,” he said.
A big caveat: the evidence isn’t deep. “Recessions don’t come along that often, so we’re talking three periods since 1990,” Colas said.
Other market analysis argues that this is not the 1970s, and oil represents a much smaller part of GDP and economic consumption than it did then. A JPMorgan analysis from last fall made the case that equity markets would hold up in an environment even with oil prices as high as $130 to $150.
Consumer demand, gas usage and the economy
Still, underneath it all, oil prices drive gas prices and the consumer is 70% of the U.S. economy. “When you take that much money out of their pocket, it has to come from somewhere else,” Colas said.
The spike in oil and gasoline prices comes just as commuting is returning to normal again as well, with more companies calling back workers across the country as the omicron wave of Covid has declined.
Office occupancy is currently running at 35%-37%, and there is about to be much more commuting and miles driven with as much as 65% of workers currently at home for at least part of the week needing to commute in, which will increase pressure on gas prices. Gas usage in the U.S. has been climbing steadily, near 8.7 million barrels, and trending up quickly.
The return to offices is not necessarily a bad thing for the economy, as urban growth relies on it, but at the same, Colas says a broader economic environment with oil prices persistently above a 100% annual increase likely outweighs those benefits to GDP: “Can we grow if oil prices stay here at 100%? Recent history says no.”
He said there is evidence from recent periods when spikes in oil prices didn’t spell doom for the economy, but there was a key difference between those periods and today. Previous periods which were close to recession-inducing levels, but when no economic contraction occurred, include 1987 (+85%) and 2011 (81%).
“The issue here is that oil prices may have risen quickly, but they were nowhere near unusually high levels relative to the recent past. Consumers, in other words, had already mentally budgeted for those levels and while they were certainly unwelcomed they were not a complete surprise,” Colas wrote in a recent note to clients. “In 1987 we got a large spike on a percentage basis, but not on an absolute basis versus the prior few years. From 2011 – 2014, the percent change off the 2009 – 2010 bottom hit 80 percent, but on an absolute basis WTI was in line with the immediate pre-crisis past.”
The S&P 500 history of oil companies
The past decade has not been kind to the energy sector of the S&P 500 and most investors are underweight energy stocks. As of now, the energy sector is 3.8% of the U.S. stock market. Even as energy stocks have bounced since the pandemic low of March 2020, their overall market profile has not risen. Consider that Apple (7%), Microsoft (6%) and Alphabet (4.2%) each have larger weights in the U.S. stock market than the entire energy sector.
Farther back, energy was 29% of the S&P 500 in December 1980 after a decade of oil shocks and huge gas price spikes. It was, more or less, what technology represents in the U.S. stock market today. Energy is a fundamental underweight, and the reason for that has been understandable: energy has been either the worst-performing or second-worst performing sector in seven of the past 10 years.
It is possible that even if oil prices are a probable cause of a recession right now, energy stocks — represented by sector ETFs such as XLE — are still buys.
This doesn’t mean energy stocks would avoid the pain of a recession. The stocks in the sector may not even be positive, but they may still outperform other sectors. “All correlations go to one if the VIX is at 50,” Colas said, referring to a measure of market volatility that would signal a crash. But he noted that the equity market, so far, doesn’t want to crash based on its rebound from spikes in the VIX into the 30s as recently as last week. And the current geopolitical events and overall supply-demand imbalance in the crude market suggest that current oil prices are sustainable. Combined with the energy sector’s diminished weight in the S&P 500, the sector’s valuation as a whole, “is just ridiculous,” Colas said.
Why it isn’t time to short energy stocks
This is not the 1970s, and energy is not going back to that prominence in the market on a relative sector basis, but as recently as 2017, when market pundits were talking about oil companies as being valued “terminally,” the sector was still over 6% of the market. Buying the trough in 2020, when the sector fell to as low as 2% of the index, was wise, but Colas says 3.8% isn’t the number that says it is time to sell. “I don’t know the right number, but I know even in 2019 it was 5% of the index.”
For Colas, doing the math on energy stocks as still being undervalued is simple: In 2011, the energy sector weighting in the S&P 500 was almost triple its current index representation, as high as 11.3%, and when energy was at similar prices. “What else do you need?” he said.
Investors should be very focused on hedging risk in the stock market right now, and maybe only in the U.S. with energy stocks. In Europe, energy stocks were hit hard last week, which shows the case for U.S. energy isn’t about oil prices alone. “European equities are just getting demolished. We don’t share a land mass with Russia,” Colas said.
All of this leads Colas to conclude that for investors looking at the stock market in this environment, “if you want to win, it’s energy.”
A recent update from S&P Global Market Intelligence showed energy shorts to have reached the highest level since 2020, but the details show that while there are a few big bets against “wildcat”-style drillers, these short bets are more likely to be in other energy niches, including in renewable energy spots like EV charging, as well as in the coal sector, rather than among the biggest oil and gas producers. The biggest U.S. oil companies, in fact, had less short interest than the S&P 500 as a whole.
“The biggest rookie mistake an analyst can make is trying to short a new high,” Colas said. “Never short a new high.”
“$130 is the max for oil,” he said. “We don’t often see more than 100% return. But oil stocks are so cheap and good dividend payers.”