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Over the past decade, the reputation of oil companies have only gotten worse and worse. Not only do they contribute to climate change, but they’re also actively draining Earth’s natural resources. So, it’s not surprising that many have been supporting renewable forms of energy as much as possible from buying electric cars to installing solar panels. Despite their efforts though, our society is still very much dependent on oil whether its to run factories or to fuel planes. And, it’s no secret that oil prices have skyrocketed over the past several months. This has caused gas prices to reach nearly $5 per gallon across the US. While this is terrible for everyday people who are just trying to make ends meet, this has been a blessing for oil companies.
Exxon’s net profits, for example, have jumped from all time lows to multi year highs, and this has sent the stock soaring. From the pandemic bottom, Exxon has skyrocketed 250% which correlates to a market cap gain of $314 billion. This has served oil investors like Warren Buffett extremely well, but this is also a terrible economic sign and here’s why.
Why Is Oil Mooning?
Before we jump into why this is terrible for the economy, we should first take a look at why oil prices are skyrocketing in the first place. At first glance, it’s easy to just blame higher oil prices on sky high inflation, but really, it’s not as simple as that. There’s a multitude of reasons behind this rise starting with an unprecedented surge in demand.
Most people have been cooped up inside their homes eversince the pandemic started. And now that covid cases are finally subsiding, people are more excited than ever to leave their city, state, or even country. Whether its a simple vacation or a trip to meet family in different states or countries, people are willing to spend significant amounts to get out. And given that the aviation industry accounts for 7.8% of global oil consumption, it’s not surprising that this V shaped recovery in airline demand has contributed to a V shaped recovery in oil prices. But, the contribution of airlines is nothing in comparison to the contribution of road based vehicles which has also boomed.
We’re seeing more people go to stores, malls, theaters, concerts, music festivals, road trips, etc. But, even more importantly, most companies have started to call back their remote employees which has led to one hour commutes becoming the norm once again for many. And with leaders like Elon Musk waging a full on war against remote work, it’s just a matter of time until more companies call back all of their employees. And with passenger cars and freight vehicles accounting for 49.3% of global oil consumption, it’s no wonder that a return to normalcy has increased demand substantially.
Aside from increasing demand, we’ve also been facing a major geopolitical conflict which is of course the Russia Ukraine war. Much of the world sides with Ukraine and to show their allegiance, they’ve been boycotting Russian goods. The US, for example, has shut off imports of Russian oil, natural gas, and coal. Russia only accounts for about 10% of the global oil supply, but this itself makes them one of the top three oil producers in the world only beaten out by the US and Saudi Arabia. So, cutting of Russian oil not only reduces supply, but it also gives other oil producers more pricing power.
One of the main reasons that oil got so cheap during the pandemic was actually thanks to Russia. You see, Russia and Saudi Arabia were having an oil war during the pandemic which pumped up oil production to 30 year highs while demand was at all time lows. This even led to oil prices going negative momentarily. But now, we no longer have Russia to play these crazy commodity games. And speaking of commodity games, the people who are most notorious for such games are no doubt Wall Street.
A solid portion of Wall Street has been speculating for oil prices to go up eversince the pandemic started, but wait a minute, how does Wall Street buying oil futures have anything to do oil prices themselves. After all, it’s not like hedge funds are directly buying barrels of oil. They’re basically just betting on whether oil will go up or down in the coming months and years. Well, here’s the thing, when Wall Street has optimistic expectations for oil prices, oil producers are less willing to sell their oil because theoretically, according to Wall Street, they should be able to sell their oil for a higher price in the future. On the flipside, oil consumers get more desperate to buy oil right now because, according to Wall Street, it’s only gonna get more expensive. So, while Wall Street doesn’t directly contribute to the supply and demand of oil, they play quite a significant psychological role. And when you combine historic inflation, a v shaped recovery in demand, the Russian boycott, and Wall Street speculation, it’s no wonder why oil prices are going to the moon.
Now that we have a better understanding as to why oil prices are skyrocketing in the first place, we can move onto its impact on the economy. In terms of microeconomics, I don’t even think I need to explain anything. For most of us, gas is an essential. You need it to go to work, shop for groceries, drop kids off at school, etc. Even if you rely on public transportation like busses and subways, it’s only a matter of time until ticket prices and annual passes increase accordingly.
Sooner or later, we’ll all be forced to allocate more money towards transportation. For many, this increase is enough to break the bank, especially for those living in high cost states like California. But, even if you’re able to afford the increased cost, your remaining budget will no doubt decrease which means less discretionary spending. And given that consumer spending is directly linked to GDP, this is not the best of signs. To make things worse, it's not just everyday people who are feeling the weight of increasing oil prices either.
Companies are very much feeling the impact as well. Now of course, there are companies that aren’t dependent on a physical product like Facebook or Google. But, most companies do rely on shipping in one form or another whether we’re talking about Apple and Amazon or Nvidia and Tesla. And as oil prices boom, so does the transportation expenses for these companies. Also, many of these companies already run on extremely thin profit margins, so increased logistical expenses alone are enough to push them into unprofitability. For example, even Amazon who has one of the most established and efficient logistical channels in the world is feeling the pain.
Last quarter, Amazon’s retail business was unprofitable both in North America and internationally. Usually, this wouldn’t be that big of a problem as companies can just pass on the increased cost to customers. But, given that people already have less discretionary income, they’re more sensitive to price increases. In fact, one survey found that 1 in 3 prime members were considering canceling their subscriptions due to the price hikes at the beginning of the year. So, many companies are stuck in this situation where they have increasing expenses but stagnating or even declining revenue. This problem is made even worse when you consider that companies won’t be able to achieve the same economies of scale with less revenue. So, their cost per dollar of revenue just becomes even worse. And in such circumstances, there’s only one obvious option and that’s layoffs.
We’re already seeing a slew of signs that companies are getting desperate to hold up revenue. For example, we’re hearing rumors that Amazon might have another Prime day in the Fall. And the timing of this is especially concerning. The fall is usually the best time for companies thanks to the holiday season. So if Amazon is already trying to boost numbers for this fall, how bad will demand be in Q1 and Q2 of next year. Clearly, we’re already starting to see the first signs of decreasing demand appear. And, if oil prices continue to stay at historically high levels, things will likely only get worse.
As companies’ earnings slide and people spend less money, we’ll see the rest of the economy follow a downward trend as well. Here’s the thing, when companies' earnings are declining, who wants to be investing in companies? Now of course, some of you contrarians out there are saying that this is the best time to buy fundamentally strong companies for the long term. And, you may very well be right, but the mob is not on your side. If they were, the stock market wouldn’t be going down in the first place. So, this means that we’re not only facing decreasing consumer spending, but we’re also facing decreasing investing. Usually, in such scenarios, the government would pump up spending, but they’re also pulling back substantially to fight high inflation.
Consumption, investment, and government spending are all going down meaning that our GDP is basically screwed at least in the short to medium term. And given that a recession is defined by two successive quarters of GDP decline, chances are pretty good that we will enter a recession.
Skyrocketing oil prices have actually been extremely good at predicting recessions historically. Not every recession is characterized by high oil prices, but everytime oil prices are high, we have a recession, and this has been true since the 1940s. Between 1946 and 1948, we saw oil prices nearly double. And shortly after we saw a recession between 1948 and 1949. Similarly, between 1973 and 1974, oil prices nearly tripled, and we once again saw a recession. We saw the same thing between 1979 and 1980, and 1990 and 1991, and 1998 and 2000, and 2007 and 2008. In fact, I don’t think there’s a single time in this 70 year graph where oil prices spiked and there wasn’t a recession. Now of course, correlation does not mean causation, but considering all of the reasoning that we’ve already discussed throughout this video, it doesn’t seem like this is just a coincidence either.
To make things worse, the most recent spike is more violent than we’ve ever seen with oil rocketing from $20 to $110 within a matter of two years. So, based on history, things aren’t looking that bright.
The Light at the End
While we may very well be in for a painful recession and rising unemployment, there are some bright spots to look forward to. Not all recessions are accompanied by a stock market crash, but given how the market has been performing so far, it definitely looks like this recession is being accompanied by one.
On average, indices typically peak 7 months before a recession and the bottom 4 months before the end of a recession. Given that the S&P 500 peaked in December, that would mean that the recession is starting right now. As for the housing market, I don’t think there’s going to be a full on crash like 2008 or anything, but a cool down is extremely likely and this could help many people buy their first home without having to bid insane amounts over asking.
Aside from providing a great buying opportunity, recessions generally wipe out the garbage on the market. And there’s no doubt loads of garbage within the stock market and especially the cryptocurrency market. I mean, I don’t even think we need to discuss NFTs or all of the dog faced coins on the market. So, this could be a great time to cleanse the space and start fresh. There may be some non financial benefits as well.
With gas prices being so high, it’s likely that many upper middle class families will make the jump to EVs, and this would be a great boost for the entire industry. But most importantly, a recession may help cool down the out of control inflation that we’re currently facing. And that may be just what we need to transition into a new period of growth and prosperity, but that’s just what I think. Do you think we’re in a recession? Comment that down below.
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