With the national average gas price hitting its highest since 2008 and the stock market nervous about Europe’s first land war since World War II being waged by one of the world’s largest crude oil producers, crude oil prices and energy stocks remain areas of focus for investors. It’s difficult for stock market participants to evade the question: Are energy stocks, which have had a tremendous run since the pandemic bottomed, still a buy given the geopolitical premium? But the related question might stop them before proceeding: Will oil prices cause a recession?
Bespoke noted last week that WTI Crude Oil is up just over 20% on the week Friday morning, one of five periods that Crude Oil has risen more than 20% in a week. It found that three of the previous four periods of skyrocketing prices occurred during recessions.
Rystad Energy, one of the world’s leading energy consulting and research firms, expects a slump in Russian oil exports of up to 1 million barrels per day – and limited spare capacity in the Middle East to replace those supplies – leading to such a net impact on oil prices are likely continue higher, possibly past $130 per barrel, and relief efforts such as releases from the Strategic Petroleum Reserve cannot make up the difference.
Of course there are differences of opinion and opposing opinions. Citi’s commodities team wrote last week that it is becoming “probable” that oil prices have already peaked or could soon consolidate near a peak. But that would require a de-escalation of Russia’s invasion of Ukraine and progress on Iran talks. US inventories are at or near the bottom, but Citi says inventory builds are underway in Q2 22.
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For Nicholas Colas, co-founder of DataTrek Researchthis is a good time to consider the value of energy stocks in a diversified portfolio and consider the risk of oil prices causing a recession.
When will oil prices signal a recession and how close we are to it
An analyst who covered the auto sector earlier in his career, Colas recalls the presentation decks used by economists employed by the “Big Three” automakers three decades ago, who have used them since the oil shocks of the 1970s.
“The rule of thumb I learned from auto industry economics in the 1990s is that if oil prices go up 100% in a year, you’re going to have a recession,” he says.
A year ago, crude oil was $63.81 (March 4, 2021) per barrel. Double that and that’s the strike price for a recession. Crude Oil is currently at $115.
“We’re close and getting there quickly,” said Colas.
“We’re at a point now where the prices at the pump on the way home from work are higher than on the way out,” Bespoke wrote in a note to customers on Friday.
But colas-added oil prices would need to persevere above that double and stay at $130 rather than just spiking and retreating quickly to worry. “A day or two is fine, but a couple of weeks isn’t,” he said.
One major caveat: the evidence isn’t deep. “Recessions don’t happen that often, so we’re talking about three periods since 1990,” Colas said.
Other market analyzes argue that this is not the 1970s and that oil accounts for a much smaller proportion of GDP and economic consumption than it did then. An analysis by JPMorgan last fall showed this The stock markets would hold up in an environment even with oil prices of 130 to 150 US dollars.
The bottom line, however, is that oil prices are driving gas prices, and the consumer makes up 70% of the US economy. “If you take that kind of money out of their pocket, it has to come from somewhere else,” Colas said.
The rise in oil and petrol prices comes as commuting is also returning to normal as more companies are recalling workers across the country as the Covid Omicron wave has receded.
Office occupancy is currently at 35% to 37% and there will soon be a lot more commuting and mileage as up to 65% of workers who are currently at home at least part of the week have to commute, which will only add pressure on gas prices. Gas consumption in the US has increased steady, near 8.7 million barrels and trending fast up.
The return to offices isn’t necessarily a bad thing for the economy, as urban growth depends on it, but at the same time, Colas says a broader economic backdrop, with oil prices persistently rising above 100% annually, likely outweighs these GDP benefits: “ Can we grow if oil prices stay at 100% here? Recent history says no.”
He said there is evidence from recent periods when oil price spikes have not spelled down the economy, but there is a key difference between those periods and today. Earlier periods that were close to recession-triggering levels, but in which there was no economic contraction, are 1987 (+85%) and 2011 (81%).
“The problem here is that oil prices may have been rising rapidly, but they were nowhere near unusual compared to recent history, which is a complete surprise,” Colas wrote in a recent note to clients. “In 1987 we had a big percentage increase, but we didn’t in absolute terms compared to previous years. From 2011 to 2014 the percentage change from the 2009 to 2010 low reached 80 percent, but on an absolute basis WTI was consistent with the immediate pre-crisis past.”
The history of the oil companies in the S&P 500
The past decade has not been good for the energy sector S&P 500 and most investors are underweight energy stocks. Currently, the energy sector accounts for 3.8% of the US stock market. While energy stocks have rallied since the March 2020 pandemic low, their overall market profile hasn’t risen. Consider that Apple (7%), Microsoft (6%) and Alphabet (4.2%) each have a larger weight in the US stock market than the energy sector as a whole.
Further back in December 1980, after a decade of oil shocks and huge gas spikes, energy was at 29% of the S&P 500. It was more or less what technology is today in the US stock market. Energy is fundamentally underweight and the reason is understandable: energy has been either the worst or second worst performing sector for seven of the last 10 years.
Nonetheless, Warren Buffett’s Berkshire Hathaway recently doubled its Chevron investment (up about 30%) and unveiled a $5 billion stake in Occidental Petroleum last week.
It’s possible that even if oil prices are currently a likely cause of a recession, energy stocks – represented by sector ETFs like XLE – will still be bought.
That doesn’t mean energy stocks would avoid the pain of a recession. Sector stocks may not even be positive, but they can still outperform other sectors. “All correlations go to one when the VIX is at 50,” Colas said, referring to a measure of market volatility that would signal a crash. But he noted that the stock market has yet to tumble based on its rebound from the VIX spikes into the 30s that occurred just last week. And current geopolitical events and the general imbalance between supply and demand in the crude oil market suggest that current oil prices are sustainable. Coupled with the energy sector’s lower weight in the S&P 500, the valuation of the sector as a whole is “just ridiculous,” Colas said.
This isn’t the 1970s, and energy won’t return to that prominence in the market on a relative sector basis, but as recently as 2017, when market pundits were talking about oil companies being valued “incurable,” the sector was still over 6% of the market . Buying the 2020 bottom when the sector fell as low as 2% of the index was smart, but Colas says 3.8% isn’t the number to say it’s time to sell. “I don’t know the right number, but I do know that even in 2019 it was 5% of the index.”
It’s easy for colas to calculate energy stocks as still undervalued: In 2011, the energy sector’s weighting in the S&P 500 was almost three times the current index figure, 11.3%, and when energy was trading 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 perhaps only in the US with energy stocks. In Europe, energy stocks were hit hard last week, showing that US energy isn’t just about oil prices. “European stocks are being destroyed. We don’t share any landmass with Russia,” Colas said.
All of this leads Colas to conclude that for investors looking at the stock market in this environment, “when you want to win, it’s energy.”
A recent update from S&P Global Market Intelligence showed that energy shorts hit their highest since 2020, but the details show that while there are some big bets against “wildcat” style drills, these short bets tend to be in Other areas have energy niches, including renewable energy areas such as electric vehicle charging, and coal, and are not among the top oil and gas producers. Indeed, the largest US oil companies had it less short-term interest rates 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 empty a new high.”
“$130 is the max for oil,” he said. “We often see no more than 100% returns. But oil stocks are so cheap and good dividend payers.”