Oil prices surge after OPEC+ cuts production: What does this mean for the economy.
A little more than three weeks after Silicon Valley’s debacle invaded the headlines of major financial news outlets, the OPEC+ cartel’s announcement of oil production cuts at the end of this month brought back fears of what will happen next to the economy in this already turmoiled market. Like everyone else, you were probably wondering what this means for an economy already struggling with inflation and high-interest rates. These ugly supply shocks created mayhem in the global economy during the 1970s and again last year after Russia invaded Ukraine. Will we see history repeat? We shall see.
The OPEC+ cartel, composed of the traditional Organization of Petroleum Exporting Countries, Russia, and a few other countries, announced a production cut at the end of this month, igniting fears of another retro oil shock. The cartel agreed to wide crude oil production cuts to 3.66 million barrels daily, comprising about 3.7% of global demand. One of the main reasons that lead to reduced oil production is the weakening global demand. After fears of a fresh banking crisis over the last month, investors have been selling commodities pushing the oil price down to $70 per barrel from near an all-time high of $139 in March 2022.
The law of supply states that prices rise in response to a decline in supply. That’s because fewer goods are now available, and you have to bid more money to access those fewer goods. Indeed, that happened as soon as the Asian markets opened on Monday when Brent crude oil jumped 8%. The graph below from StockCharts shows the increase in crude oil as soon as the market opened after the announcement.
Now this is concerning as this sends ripple effects across the prices of other goods and services in the economy. With oil being a significant input in most production processes, an increase in oil prices will inevitably translate into a rise in the price of goods. This is not something we really want in an economy that has just slowed down scary inflation rates.
While an increase in oil prices can indicate growing demand and economic strength, it can also create a downturn in growth, just like it did in the 1970s. Oil prices were seen as a proxy for global demand for the past years until last summer. That’s because most of these increases in oil prices came from growing demand apart from when the Russian war took place. Business activity was increasing; hence, companies bought more oil to produce more, suggesting a growing economy where everyone consumes.
You can see in the chart above from Yahoo Finance the relationship between stocks and oil parting ways. The green line represents oil prices, whereas the red line points to the S&P 500. Both experienced similar upsides as well as downsides. There was a correlation between oil and stocks up to mid-2022, when they started to part ways. The parting ways are due to oil prices hitting an extreme due to the Russian UkranianWar, after which its decline was seen as more of a relief than bad news for stocks.
Although increases in oil prices can suggest that there’s economic growth and a healthy economy, that’s mostly the case when there is a demand-pull rise in oil prices. Supply shocks in oil prices usually come with an economic downturn, as happened during the 1970s. That’s because the rise in oil prices negatively impacts and shrinks demand. So today’s increase in oil prices isn’t going to push stocks higher.
Matt Maley, the chief market strategist at Miller Tabak + Co, wrote, “If the price of oil is going to remain high due to supply issues rather than demand issues, those supply-induced higher prices will have a negative impact on demand.1” That suggests that the latest increase in oil prices will not indicate a pickup in demand; instead, it suggests that it can lead to a downturn in growth as it did in the 1970s. He further writes that “A supply-induced rise in oil prices is not good for an economy, especially one that is very likely just about to face a significant contraction in the supply of credit.1“
This suggests that the recent increase in oil prices will lead to the growth taking over from inflation as the greatest cause of concern. We have an already struggling demand due to high borrowing rates. We also have data from the Purchasing Manager’s Index that suggests that growth is slowing down.
Then there is also the PMI data that suggest that economic growth is not looking very healthy. PMI stands for Purchasing Managers’ Index, an economic indicator that measures the economic activity level in an economy’s manufacturing and services sectors. It is calculated by surveying purchasing managers in various industries to gather information on new orders, production, inventory levels, and employment factors.
A PMI above 50 indicates that the economy is expanding, while a reading below 50 suggests the economy is contracting. This is because a PMI above 50 indicates that more purchasing managers are reporting an increase in economic activity than those reporting a decrease. The current from TadingEconomics in the chart below suggests that the economic level in the manufacturing and services sectors has fallen to levels seen during the COVID pandemic.
One might rightfully ask what will be the driving force behind consumer sentiment and consumer spending in an economic setting where energy and gasoline prices are going to be more expensive due to the production cost. On top of that, the interest rate is the highest since 2007, adding more pressure to consumer spending.
To sum up, the recent surge in oil prices and the OPEC+ cartel’s production cuts have created uncertainty in the economy. While there are concerns that rising oil prices could lead to inflation and a slowdown in economic growth, the market reaction suggests that growth is now the primary concern. Ultimately, the implications of this surge in oil prices will depend on various factors, including the pace of economic recovery, geopolitical tensions, and environmental policies. Nevertheless, the energy sector will continue to play a critical role in shaping our economy. It will be essential to monitor developments in this area closely.
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