Many factors impact oil prices but most importantly, supply and demand. While supply focuses on the ability and willingness of countries and private companies to produce oil, demand is a function of economic growth. When growth is strong, generally, prices are supported as consumers travel, commerce is upbeat, and transportation rises. When economic growth is declining and consumers are reducing their spending, consumption of oil products like gasoline, diesel, and jet fuel decline, putting downward pressure on prices.
Central banks worldwide have raised interest rates to fend off rising inflation expectations. The impact of higher rates reduces inflation and undermines economic growth by reducing borrowing. While many forecasted a recession, the higher rates by central banks have yet to reduce growth significantly. The impact of higher rates has yet to be felt by many segments of each economy, but if a global recession occurs, demand for oil and products will drop, putting further downward pressure on oil prices.
What is a Recession?
A recession is a period of economic decline, typically defined as two consecutive quarters of negative economic growth. Most countries use a statistic called Gross Domestic Product to measure economic growth. During a recession, businesses may experience decreased profits, increased unemployment, and reduced consumer spending. While a recession has a specific definition, growth below the trend can also be a problem for consumer spending. For example, the long-term average GDP growth rate in the United States is about 3%. If growth is 0.2% for two consecutive quarters, a recession has not occurred, but consumer spending and a decline in corporate profits could be meager.
The most important part of GDP is consumer spending. In many countries, consumer spending can make up more than 50% of GDP. Various factors, including income, savings, access to credit, consumer confidence, and the overall economic environment impact consumer spending. Changes in any of these factors can directly impact consumer spending. For example, an increase in income may lead to increased spending, while a decrease could lead to a decline. If you lose your income because of a downturn in employment, your spending could decrease significantly.
What Causes a Recession?
A recession is typically caused by a combination of economic factors, including an increase in unemployment, a decline in housing prices, and a tightening of credit. Other factors that can contribute to a recession include a decrease in business investment, a decrease in government spending, and an increase in inflation. Tigh credit is usually a function of interest rate increases by a central bank looking to reduce inflation by increasing borrowing costs.
How Does a Recession Usually End?
A recession usually ends when the economy begins to grow again, usually caused by increased consumer spending, business investment, and government spending. Generally, a central bank will signal at first to the markets that it plans to reduce rates and become more accommodative. After the bank signals its intention, it usually decreases interest rates to spur growth and consumer spending. This growth in economic activity leads to an increase in employment, wages, and incomes, which in turn leads to more consumer spending and business investment. This cycle of increased economic activity is known as an economic expansion.
What is the Likelihood of a Global Recession
In early 2023, the World Economic Forum surveyed economists to determine the likelihood of a global recession. At that point, about 66% of the economists polled believed a global recession would occur in 2023. The figure was more than double since a similar poll was taken about 4-months earlier. Higher interest rates in several large OECD countries have pressured GDP and consumer spending.
How Does Crude Oil React to a Potential Recession
Oil prices have declined significantly since central banks worldwide started raising interest rates. The Federal Reserve in the United States began to raise interest rates in early 2022. Since their tightening campaign started, oil prices have declined to about $70 per barrel on a WTI basis from more than $130 a barrel, making crude oil investing in higher prices challenging. (see chart)
The reason for the decline was a fear of contracting demand due to higher interest rates that stifled consumer spending. When consumer spending declines, people purchase fewer items that need to be shipped from one point to another. Consumers are less likely to take road trips or travel via air or train. The decline in consumer spending directly impacts gasoline and diesel demand, which weighs on crude oil prices. Additionally, when the economy is in a recession, businesses may reduce their production, which can also lead to a decrease in demand for oil.
How Did the 2008 Recession Impact Oil Prices?
During the great recession of 2008, there was a significant impact on oil prices. Oil prices fell from a peak of $147 per barrel in July 2008 to a low of $33 per barrel in December 2008. This move was due to a decrease in global demand for oil due to the recession. The reduction in demand far exceeded supply, putting downward pressure on crude oil prices.
When does Will Central Banks Start to Become More Accommodative?
Each central bank will follow a different path. Most major banks have one mandate. For example, the European Central Bank (ECB), the European Union’s central bank, is mandated to maintain price stability in the euro area. The ECB’s primary objective is to ensure price stability, defined as inflation below, but close to, 2% over the medium term. The ECB also supports the general economic policies of the European Union, including promoting economic growth and employment.
The Federal Reserve has two mandates. The Federal Reserve’s mandate is to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. The Fed does not have a set timeline for it to become accommodative. The Federal Reserve’s monetary policy decisions are based on various economic indicators, and the timing of any policy changes will depend on the economic conditions. The Fed generally focuses on the BLS unemployment rate and the core Personal Consumption Expenditure reported by the U.S. Commerce Department.
What is Core PCE
Core Personal Consumption Expenditure is a measure of inflation used by the Federal Reserve to track the prices of goods and services purchased by individuals. It is calculated by the Bureau of Economic Analysis and is used to measure the economy’s overall health. The Fed targets 2% inflation; the March 2023 core PCE was still above that level at 4.6%.
Where Do Oil Prices Stand?
According to the Energy Information Administration, crude oil and product demand growth face the risk of lower prices through the end of 2024. The increase in demand for gasoline generally generates a seasonal rise in oil consumption, which will coincide with a decline in OPEC crude oil production. The perceived lower supply and increased demand could put upward pressure on crude oil prices.
The EIA forecasts that global petroleum consumption could increase by 1.6 million barrels per day in 2023 and by 1.7 million per day in 2024, with most of the demand growth, is in non-OECD Asia, led by China. China has not been tightening interest rates as the lockdown created a substantial contraction in growth.
The EIA sees an expansion of crude oil inventories globally beginning in 2024. Production could outpace demand putting downward pressure on crude oil prices.
The U.S. Government will be a Buyer
The Biden administration reported that it should begin purchasing oil to replenish the Strategic Petroleum Reserve held by the United States. Recall that the U.S. used a substantial part of the reserve to keep prices down as OPEC reduced production. The goal is to refill the emergency reserve after completing maintenance work later this year, giving an updated outlook on the timing for the refill. The government said in a statement that it planned to purchase at $70 per barrel. Later in the year, following the seasonal increase in demand could be a prudent time for the government to buy oil at lower prices to refill the reserve.
The Bottom Line
The Upshot is that a recession generally weakens oil prices. While supply can be reduced to offset the potential decline in demand, sentiment is usually harmful. Oil demand is driven by consumer and company spending. If the consumer is not spending, that movement of goods contracts. Transportation generally declines. People will stop taking discretionary trips and make fewer trips to the supermarket to conserve their transportation spending. One of the reasons that demand has been impacted is that central banks worldwide have been raising interest rates. When rate increases stop and potential begins to go down, prices will be able to climb. Until that occurs, oil prices are likely to face headwinds.