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The Big Conversation

Episode 143: Could higher oil help?

This week we look at the prospect of a higher oil price through the midterms and into year end, and the surprising effects that could have on the consumer.

Last week OPEC+ made the decision to cut oil production and it had the desired effect, a higher oil price. But couple this with less barrels from the Strategic Petroleum Reserve post-midterms in a month, and we could see oil grind higher into year-end. Now, the question is how this affects the consumer and therefore the Fed’s next moves. If higher oil leads to job losses and resets wage expectations for the private sector then it could, in fact, help the Fed. The Fed must tackle wage inflation too, and it just might be oil that buys them more room to move.

  • Jamie M [00:00:00] It's been a minute since we focused on energy prices on this show and for good reason too. Having been front and centre of headlines in the U.S. going into the summer, oil in particular has slowly pulled back to much more digestible levels for the average consumer and car driver, and that's in large part due to the Biden administration releasing millions of barrels from the Strategic Petroleum Reserve. But just recently, we may have seen the beginning of a turn. Last week, the Organisation of Petroleum Exporting Countries and Russia, known collectively as OPEC+ took the decision to reduce their production of oil by 2 million barrels per day. Now, unsurprisingly, this has given oil a nice bid over the last week, which was the exact intention of those making the decision. They didn't like the falling price, so they cut supply. The question then becomes if on top of this, the recent SPR releases start to slow and oil continues its rally, what are the domino effects to the consumer? Are households now facing a renewed threat from energy prices? And is that enough to affect the negotiations going on right now regarding wage increases? And that's this week's Big Conversation. 

    Jamie M [00:01:20] Now we don't need to completely rehash the inflation story of 2022. I think many of you at home know it all too well. But it is important to recognise the relationship between commodity prices and wage inflation. What began as inflationary pressure driven very much by energy prices, amongst other things, then translated into upward pressure from wage increases to keep pace with a rise in the cost of living. But then we saw oil and energy prices come off over the summer and into fall, much to the pleasure of President Biden, and largely due to the continued supply of oil from the Strategic Petroleum Reserve. Now, last week, we saw the DoE release a statement allowing more barrels to get released. But the President is running out of firepower from the SPR. And this fire is further fueled with accusations that he's raiding America's emergency reserves to hide a problem which he doesn't know how to fix. And so it's possible that without major releases past November's midterms, that we see oil on a run higher into the New Year. Now, there are obviously unresolved geopolitical tensions in the world right now that could influence oil, but it's important to note that there is a plausible playbook out there that means we could see continued higher oil for a while. So why are we tying this to wage inflation? Well, energy prices drove up the cost of living, and that led to higher wages, but for how long? The fact is that wage inflation is far stickier. And herein lies the problem. Just think about it. Energy bills could change on a dime from month to month, but wages often get negotiated for a year at a time, so they are harder to pivot when the economy is moving around. And this brings up a really important point. Debate is rife in the U.S. right now as to whether the Fed will need to hike fast to shock wage inflation into reversing. I think right now many of us are hoping that hiking to 4 or 5% is enough to cool inflationary price increases. But if wage inflation continues to run hot, then the Fed will have less room for manoeuvre, and they may need to hike sharper and higher to 6% or so, and that's when you will see certain parts of the market breaking, like housing or pensions, for instance. But here's a more positive spin that we think posits reflection. Maybe, just maybe, this latest rally in oil is good for markets because it changes the conversation that employees are having with their employers. As equities continue to struggle, as rates continue to rise and now as energy prices creep higher, does the consumer start to think more rationally about asking for a wage increase? Or does this soft landing scenario feel more likely with higher oil as we see more Americans resort to being happy at keeping their job? It's an interesting take, but be aware that this is in reference more to private sector jobs. An uptick in oil will likely drive wage demands of public sector workers higher still, whereas it's in the private sector that there's more employer power when it comes to reducing the workforce. And workers may therefore be more cautious over their timing of asking for a raise. So be sure to look out for commentary from corporate America on wages going up or down, because that will be crucial for where rates go. Now, before we conclude, I wanted to just mention an interesting comment we just got from Fed Governor Brainard. She said, and I quote, "There is ample room for margin compression to help reduce goods inflation as demand cools, supply constraints ease and inventories increase.". 

    Jamie M [00:05:00] Now, this can be interpreted in different ways, but essentially the point is that corporate America is still posting healthy profits and can afford to absorb rising input costs, including wages, rather than passing them on to the consumer via price increases, for now at least. Some have argued that 1970s inflation was underpinned by the power of unions. But this year's inflation is driven by corporate America being unwilling to take a hit on margins and passing on all costs to the consumer. Well, that is now what Fed Governor Brainard is arguing against. She thinks companies can afford to let margins fade. And this will be a very interesting story to watch play out, particularly for equity investors. 

    Jamie M [00:05:44] So what are the signs that we should all be looking out for to see how these market themes play out? Well, first and foremost, keep your eye on the President's intention whether or not to release more barrels from the SPR. It's a political hot cake, so I am sure there'll be lots of attention around it going into the midterm elections in just under a month. Secondly, I'm not sure we will hear anything from OPEC+, but any statement from them in and around the price of oil will certainly have an impact. And then depending on how oil and energy prices trade from here, pay attention to the commentary in the Q3 earnings calls. It's always so important not only to see where the companies are beating or missing expectations, but also to see what their outlook is, and that includes hiring and firing. So much rests on the level of unemployment right now that if you sense a pickup in job losses, then that is something the Fed is watching closely and will be a driver of their rate hike decisions from here. And don't forget to watch out for commentary on whether companies are passing on higher prices or not, and that includes wages. Remember, a slow tick-up in unemployment is on balance helpful for the Fed as it helps them put ice on the fire of wage inflation. But a sharp pick up in unemployment is not a welcome sign, as then we are likely to see a material pickup in defaults, and that's not what we want at a time when the housing market is at best cooling off. In short, oil is possibly on the move again, and it's particularly worth watching over the next month as there are various political irons in the fire surrounding it. If oil steadies at this level and we see a marginal but digestible pickup in unemployment leading to a cap on wage inflation, then a soft landing could very much be on the cards as it gives more room for the Fed to pivot. But any deviation away from that plan, and it could well be oil that upsets the apple cart and the markets could be in for further volatility. Now to discuss many of these issues, including what it would take for the Fed to pivot, Real Vision's Roger Hirst sat down with David Rickard, Director in Trading Solutions at the London Stock Exchange Group.