Oil prices are down, but the economy shouldn’t slow down

In recent Simply put commentaries, we argued that market fears of a recession in the near-term due to monetary-policy tightening were unfounded, and that the current expansion was supported by low long-term interest rates.  Here we explain why a fall in the price of oil doesn’t necessarily signal a downturn.

 

Need to know Oil prices declined in November as the euro weakened, covid-19 infections surged and real rates remained negative. Falling oil prices and a drop in excess demand are often associated with looming recessions. But we believe this decline more likely reflects increased supply – which could actually help moderate inflation in the coming months.

 

Sliding into recession?

The price of oil has slipped from its October high. This fall, accompanied by a weaker euro and negative real rates, could imply the market is becoming more bearish. Should we be alarmed?

From a macro perspective, the drop in oil prices could be of concern. Figure 1 tracks the oil price in reference to all US and European recessions since 1984. The chart clearly shows that a recession, irrespective of length, is traditionally accompanied by lower oil prices (although the converse is not true). For example, oil fell 68% during the 2008 Global Financial Crisis and dropped 44% in 2015 throughout the China slowdown. In the most recent sell-off, caused by the onset of the pandemic in March 2020, oil prices plunged 54% and provided the only recession signal as no other data point reflected economic activity grinding to a standstill.

The recent weakness of the euro, on the back of another covid-19 flare-up, could signal a slowdown in economic activity – especially for bearish market observers .

 

Figure 1.  Economic slippage: US and European recessions have coincided with oil-price declines

Source: Bloomberg, LOIM as at November 2021. Recessions are calculated using an aggregation of data from the National Bureau of Economic Research and Center for Economic Policy Research.

 

The bearish view

Bears might argue that oil prices are falling with excess demand. This is usually a recession signal and cause for concern. Figure 2 illustrates excess demand for oil, calculated as demand minus supply in million barrels per day, versus oil prices. The general pattern is logical: when demand exceeds supply, the price tends to increase, as shown by the recovery from the 2008 crisis. Recently, we have observed that demand is greater than supply to the volume of about 1 million barrels, which explains the accompanying rise in oil prices. It follows that excess supply tends to drive down prices, as shown in the period 2015-2016.

The data suggest excess demand has declined since June 2021. Even though we won’t know the full Q4 data until 2022, the change in prices – especially the declines during the last four weeks – hint that excess demand has decreased further. This could either be because demand is falling, which would be a clear concern, or that supply is increasing. What is our view?

 

Figure 2. Excess oil demand relative to prices

Source: Bloomberg, LOIM as at December 2021. Excess oil demand calculated as demand minus supply in million barrels per day.

 

Why is excess demand easing?

There is no cause for panic, in our view. We believe excess demand is weakening because supply is increasing. Indeed, the US is releasing 50 million barrels from its strategic oil reserve, which may prompt other countries, notably China, to take similar measures.

That supply is rising to meet demand is a positive sign as it eases pressure on consumers. However, it could easily be a false alarm, as was the case in 2005, when decreasing excess demand was not accompanied by a fall in the price of oil: from March to August 2005, oil prices increased 24% while excess demand fell into negative territory.

Therefore, rather than viewing the current price decline as a negative event, or a harbinger of recession, we see it as a sign that one of the bottlenecks causing current levels of high inflation is being opened up. After all, surrounding macro indicators are positive:

• Growth expectations remain excellent: the IMF projects 4.9% global growth for 2022
• Real rates have moved from -0.92% (1 November) to -1.17% (9 November) and back up to -0.97% (23 November)
• Ongoing fiscal stimulus continues to provide support

Simply put, the current slide in oil prices is driven more by increasing supply than weakening demand. Recessions are typically accompanied by lower oil prices but not all declines signal a slowdown . In our view, the current situation reflects the latter.

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