Oil prices – and price momentum – have been strong recently. This is despite concerns about global growth momentum, with China and Europe stalling and U.S. manufacturing recovery suggesting a recession.
In fact, Brent crude prices have recently surpassed $90 per barrel. Oil supply-demand dynamics remain tighter than expected, largely driven by the efforts of OPEC+ to keep barrels off the markets. Further news out of Saudi Arabia and Russia that they will extend their export cuts through December helped oil prices break out of a multi-month range.
This breakout in oil prices could spoil a lot of consensus trades that have worked this year. Oil is the truth, so when it speaks, we need to listen.
Why Oil Prices Are Heating Up Now
There have been several drivers of the recent breakout in oil price momentum that are worth noting. On the demand side, a still robust U.S. labor picture has kept demand for gasoline strong. Retail prices now are at multi-year highs for this time of year. While the Federal Reserve has been in tightening mode over the last 18 months, any real direct impact on gasoline and diesel demand has been largely muted.
On the other side of the world, China has continued buying oil all year, adding to its strategic reserves. As China enacts more stimulus to assist its struggling economy, oil demand trends will be even better in the second half of the year.
On the supply side, OPEC+ has done a lot of work keeping barrels off the market. It has tried to best match supply with demand in order to keep the oil price momentum going. But two actions by the U.S. government have also had implications on the overall supply side. These both now will help keep supply-demand tighter going forward.
Over the last 18 months, the U.S. government significantly drained the Strategic Petroleum Reserve down to levels last seen in the early 1980s to help keep oil prices under pressure. But these efforts have now been largely exhausted as the government has announced plans to start rebuilding strategic stockpiles again. This is going to add more buying pressure to the oil market.
As the government embraced the idea of trying to keep oil prices down, this had a significant knock-on effect as oil producers began to cut the amount of oil rigs working on drilling for oil. The oil rig count in the U.S. is down close to 18% this year and as a result, shale oil production in the U.S. has likely peaked again. This will make it difficult for oil producers to quickly turn back on their rigs to take advantage of the higher oil prices, only exacerbating the supply issues and leading to more pricing pressures.
The most recent news aiding the oil market in the last few trading days seems to be the recent announcement by Saudi Aramco that it is looking to raise up to $50 billion in equity capital in the coming months. As Aramco looks to raise capital, it will ensure that oil prices stay firm throughout the process.
What the Crude Surge Means for Markets
Continued strength in oil prices has far-reaching macroeconomic implications. There is a tight correlation between gasoline prices and inflation expectations. As a result, the recent reacceleration in oil prices is likely to trigger an increase in consumer expectations of rising prices.
The Federal Reserve’s tightening agenda has been slowing down over the course of the year. Investors now expect the Fed to hold rates steady at its upcoming September meeting. However, a reacceleration of inflation could put rate hikes back on the table for later this year.
With financial markets currently pricing in rate cuts as early as 2024, the Fed may have to push back against this pricing dynamic at the meeting. This could lead it to further push up interest rates in order to bring inflation back down to the 2% target. Higher gasoline prices are also going to further crimp low-end consumer budgets. In turn, this will threaten discretionary spending in the coming months. This will be an earnings growth headwind for countless consumer-facing sectors like retail and apparel.
How to Profit and Protect Your Portfolio
Oil prices can have far-reaching portfolio implications. This most recent breakout in oil prices seems to have legs to it as supply-demand dynamics favor rising prices.
A pickup in inflation expectations is going to further pressure the bond market. There, I would expect yields to continue rising.
Investors would be best served with maintaining a defensive posture in their portfolios here. They should focus on cash and short-term cash equivalents rather than chasing for duration. Be warned: Oil price momentum could wreak havoc on the economy.
On the date of publication, Craig Shapiro did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
