Oil Prices and the Fed Fighting Inflation
Stocks are rebounding this week after getting slammed in April. Much of this volatility may be driven in part by the “Fed fighting inflation” headlines working to achieve its 2% CPI mandate, more so than actual economic data points.
Old school or not, while various central banks have different inflation targets, the 2% figure gained popularity, partly due to its use by the Reserve Bank of New Zealand over three decades ago in the early 1990s. This target was seen as low enough to maintain price stability but high enough to provide some flexibility for monetary policy.
Whether central banks should adjust the target to a higher level like 3% and call it a day, depends on various factors including economic conditions. Considering that over the past few decades we had persistently low inflation, history most likely will eventually repeat over time. Regardless of the Fed’s inflation target, moving to quick to cut rates to the downside could send us back to the 70’s leading to future hikes or a harder landing.
Bad News is Good News – US Labor Market
This week the notorious Fed Chair Powell held rates steady, while mentioning lack of inflation progress. The tepid bad news of the US labor market cooling last month as both hiring and wage growth slowed more than economists had expected was good news for stocks.
The US economy added 175,000 new jobs and the unemployment rate rose to 3.9% last month, new data from the Bureau of Labor Statistics showed Friday. The slowdown in wage growth in April also aids the situation for the Fed to eventually cut interest rates at some point later this year, even as inflation data has remained higher than expected.
Bad News is Bad News- Oil Prices and the Fed
With many factors driving markets today, perhaps the most uncertain is the impact geopolitical conflicts could have on the price of oil. The world is still highly dependent on oil with a global demand estimate of 102 million barrels per day in 2023 according to the International Energy Agency. Thus, oil is a way for geopolitical instability to be transmitted to the global economy since conflicts can disrupt oil production and supply chains, driving prices higher. Most importantly in today’s economic environment, rising oil prices will lead to higher inflation, impacting consumers, Fed decision-making, and interest rates.
While Iran, the third largest producer in the Organization of the Petroleum Exporting Countries (OPEC), produces about 3 million barrels of oil per day (bpd), or only around 3% of total world output according to Reuters, any supply shift due to a direct war with Iran could have a seismic effect thereby pushing crude prices up substantially for some time but not permanently.
While both the CPI and PCE inflation indices downplay energy and food prices in their calculation, any spike in oil will certainly throw off the inflation fight by the Fed. Powell’s gloves may come off if there is a direct conflict with Iran with sustained higher crude prices that could blow past 140. This could be a black swan event to keep an eye out for. Even today’s elevated oil and gas prices may make the Fed’s 2% CPI goal a bit difficult to achieve anytime soon.
For example, Russia’s invasion of Ukraine in early 2022 led to a spike in oil prices to over $127 a barrel, the highest since July 2008. This is an important reason headline inflation, including the Consumer Price Index (CPI), jumped to four-decade highs a few months later. Gasoline prices at the pump rose to near $6 on average across the country, hurting consumer sentiment and leading to fears of a recession. Oil prices did eventually settle down to near $70 last summer and have been relatively calm in recent weeks amid rising tensions between Israel and Iran as well as shipping disruptions in the Red Sea.
Oil prices are up
Oil prices are about 8% higher this year with Brent crude and WTI recently trading around $87 and $83 per barrel, respectively. (see chart) This pushed the energy component of CPI higher in February and March, propping up overall inflation . While economists tend to focus on core CPI which excludes food and energy prices, it’s impossible to ignore the impact higher oil prices have on consumers and economic growth. Thus, oil remains a wildcard when it comes to monetary policy and the timing of the Fed’s first rate cut. It’s of no surprise that the projected six Fed rate cuts of last fall have now dwindled down to only one or two, if any.
The U.S. is the largest producer of crude oil in the world
On a positive note, an important difference between today’s inflationary environment and that of the 1970s and early 1980s is that the U.S. is now the largest producer of both oil and gas in the world. The U.S. has produced more crude oil than any other nation over the past few years. Domestic oil production has fully rebounded from the pandemic and now exceeds 13 million barrels per day, (see chart) more than Saudi Arabia, Russia, and other members of OPEC+. There have also been hopes that the U.S. would play the role of a “swing producer” to raise production when required by global supply and demand. In theory, greater energy independence is one reason the U.S. may be more insulated from global events than in the past.
That said, the U.S. is still dependent on oil imports for a variety of reasons, including the type and quality of crude oil. Although the U.S. theoretically produces enough oil to meet its energy needs, overseas oil is often cheaper than domestically produced crude due to a variety of other factors. In recent years, Canada, Mexico, and Saudi Arabia have been the largest sources of U.S. imports of foreign oil. U.S. imports from OPEC countries have declined to just 15% from a peak of over 70% of U.S. crude oil and petroleum imports in the late 1970s. However, since oil is a global commodity, price swings still impact U.S. producers and consumers despite strong U.S. oil production and strong trading partners.
Biden’s Green Energy Mandates
Regarding the impact of Biden’s oil production mandates and the decision to halt the Keystone XL pipeline on American oil independence consider the following points.
Oil Production Mandates: The Biden administration has pursued policies aimed at balancing environmental considerations with energy security and economic priorities. While certain regulatory changes may have affected domestic oil production in the short term, the long-term impact on American oil independence depends on various factors, including technological advancements, market dynamics, and the development of alternative energy sources. Additionally, the administration has emphasized the importance of reducing reliance on fossil fuels and transitioning towards cleaner energy sources as part of its broader climate and environmental agenda.
The transition to green energy and the adoption of electric vehicles (EVs) are crucial steps in addressing climate change and reducing reliance on fossil fuels. However, the reality is that the world’s energy infrastructure is heavily dependent on oil, natural gas, and coal that still supply about 80% of the world’s energy and have done so for over 150 years. It could take many decades for this to change course from technology to affordability.
Keystone XL Pipeline: The decision to halt the Keystone XL pipeline project has been a subject of debate, with proponents highlighting potential environmental risks and opponents criticizing its impact on energy security and economic growth. While the pipeline could have facilitated the transportation of oil from Canada to the United States, its cancellation is unlikely to have a significant impact on American oil independence given the diverse sources of domestic and imported oil.
Investing In Energy
From an investment perspective, the energy sector is a volatile but important component of a diversified portfolio. Interestingly, the sector has behaved quite differently from the rest of the market over the past several years. For example, during the 2022 bear market caused by inflation and recession fears, rising oil prices propelled the energy sector to a total return of 65.7%, (see chart) adding to its significant gain in 2021. This was also a reversal of the trend that began in 2014 when the energy sector was among the worst performers most years due to overproduction and low oil prices.
This year, the energy sector has generated a total return of 14.5% and is now the best performing sector. (see chart) While there is no guarantee that the energy sector will always perform well during periods of geopolitical uncertainty, it remains an important part of a balanced portfolio that can help investors to weather volatility and stay focused on long-term financial goals.
The bottom line? Geopolitical instability can drive up oil prices and spur inflation, muddying the economic and interest rate outlook. Investors should continue to stay invested and focused on long run trends.
For more information on our firm or to request a complementary investment and retirement check-up with Jon W. Ulin, CFP®, please call us at (561) 210-7887 or email jon.ulin@ulinwealth.com.
Note: Diversification does not ensure a profit or guarantee against loss. You cannot invest directly in an index.
Information provided on tax and estate planning is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss. All examples and charts shown are hypothetical used for illustrative purposes only and do not represent any actual investment. The information given herein is taken from sources that are believed to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as NewEdge Advisors, LLC does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.
