What are the indicators of an oil price-induced recession and what investments should be made?

• Recent filings show that Berkshire Hathaway, led by Warren Buffett, invested $5 billion in Occidental Petroleum and increased its stake in Chevron by doubling its previous investment.
• The year-over-year increase in oil prices is approaching 100%, while gasoline prices in the U.S. have surpassed $4 and reached their highest level since 2008. This is due to the huge single-day spikes caused by Russia's invasion of Ukraine, which has exacerbated existing energy inflation.
• During periods when oil experienced a 100% increase in value within a year, such as in 2008, recessions often followed. Although this would negatively impact both crude prices and the stock market, there is still a compelling argument for investing in energy stocks due to the sector's reduced representation in the S&P 500, at just under 4%.

The national average for a gallon of gas has reached its highest price since 2008, and the stock market is on edge due to the first land war in Europe since WWII being waged by one of the world's biggest crude oil producers. As a result, crude oil prices and energy stocks are a focal point for investors. It is challenging for stock market participants to ignore the question of whether energy stocks, which have experienced a significant increase since the pandemic low, are still a wise investment given the geopolitical premium. However, a related question may halt them before proceeding: will oil prices cause a recession?

Last week, Bespoke observed that WTI crude oil had increased by more than 20% from the previous week, making it one of the five times in the past year that crude oil had rallied by more than 20% in a week. Notably, three of the four previous periods where prices surged occurred during recessions.

According to Rystad Energy, a leading global energy consulting and research firm, a significant decrease in Russian oil exports of up to 1 million barrels per day, coupled with limited Middle Eastern spare capacity to replace these supplies, is likely to cause oil prices to rise further, possibly beyond $130 per barrel. Despite relief measures such as releases from the Strategic Petroleum Reserve, the net impact is expected to be a continued climb in oil prices.

Citi's commodities team believes that oil prices may have already peaked or will soon stabilize near a peak. However, this is contingent on a de-escalation of the Russia invasion of Ukraine and advancements in Iran talks. Despite low U.S. inventories, Citi predicts stock builds in the second quarter of 2022.

It is a good time for Nicholas Colas, co-founder of DataTrek Research, to consider the value of energy stocks in a diversified portfolio and how to assess the risk of oil prices causing a recession.

How close are we to a recession when the price of oil signals it?

Colas recalls the presentation decks used by economists at the "Big Three" automakers in the 1970s, which they still used three decades later.

According to the auto industry economics expert, if oil prices increase by 100% in a year, a recession is likely to occur.

A year ago, crude oil was $63.81 a barrel. If that price is doubled, it is the strike price for a recession. On Friday, WTI crude was at $115, and by Monday, it had reached the $130 level as discussions between the U.S. and allies about a ban on Russian oil imports intensified.

“We are close and getting there fast,” Colas said.

On Friday, Bespoke informed clients that prices at the pump were higher on the way home from work than on the way in.

To be concerned, Colas added oil prices would need to remain persistently above $130, rather than just spiking and quickly dropping back down. According to him, "A day or two is okay, but a few weeks is not."

Since 1990, there have been three recessions, which is not a common occurrence.

JPMorgan's analysis from last fall suggests that equity markets will remain stable even if oil prices rise to $130 to $150. However, other market analysts argue that the 1970s oil market was much larger than today's, and its impact on GDP and economic consumption is significantly reduced.

Consumer demand, gas usage and the economy

When you remove a significant portion of money from consumers' pockets, it must be replaced from another source.

As the omicron wave of Covid declines, the spike in oil and gasoline prices coincides with the resumption of commuting and the return of workers to their offices.

With the increase in office occupancy from 35%-37% and the need for more commuting and miles driven as 65% of workers return to the office, gas prices are likely to rise. Gas usage in the U.S. has already reached 8.7 million barrels and is expected to continue climbing.

The return to offices may not necessarily have a negative impact on the economy, as urban growth depends on it. However, Colas argues that a broader economic environment with oil prices consistently increasing by more than 100% annually could outweigh any benefits to GDP. According to recent history, if oil prices remain at this level, economic growth is unlikely to occur.

Recent periods have shown that spikes in oil prices did not necessarily lead to an economic downturn, as seen in 1987 (+85%) and 2011 (81%). However, there is a significant difference between these periods and the current situation.

Oil prices may have risen quickly, but they were not unusually high relative to the recent past. Consumers had already mentally budgeted for those levels, although they were certainly unwelcomed, but not a complete surprise. In 1987, we experienced a large spike on a percentage basis, but not on an absolute basis versus the prior few years. From 2011 to 2014, the percent change off the 2009-2010 bottom hit 80%, but on an absolute basis, WTI was in line with the immediate pre-crisis past.

The S&P 500 history of oil companies

The energy sector has not fared well in the past decade, with most investors underweighting energy stocks. Currently, the energy sector accounts for only 3.8% of the U.S. stock market. Despite a recent rebound from the pandemic low of March 2020, the overall market profile of energy stocks has not improved significantly. It's worth noting that companies like Apple (7%), Microsoft (6%), and Alphabet (4.2%) each have larger weights in the U.S. stock market than the entire energy sector.

In December 1980, energy accounted for 29% of the S&P 500 after a decade of oil shocks and gas price spikes. Today, energy represents what technology does in the U.S. stock market, which is a fundamental underweight. The reason for this is clear: energy has been the worst-performing or second-worst sector in seven out of the past 10 years.

Warren Buffett recently increased his investment in by about 30% and last week disclosed a $5 billion stake in the company.

Even though oil prices may be a potential reason for a recession, energy stocks, represented by sector ETFs such as XYZ, are still considered a good investment.

Energy stocks may not perform well in a recession, but they may still outperform other sectors. According to Colas, the equity market is not interested in crashing, as evidenced by its rebound from highs in the VIX to the 30s. The current geopolitical events and supply-demand imbalance in the crude market suggest that current oil prices are sustainable. Additionally, the energy sector's weight in the S&P 500 is diminished, making its valuation "just ridiculous."

Why it isn’t time to short energy stocks

In 2017, despite predictions that oil companies were "terminally" undervalued, the energy sector still comprised over 6% of the market. However, buying the sector in 2020, when it fell to 2% of the index, was a wise decision. According to Colas, while the sector is currently at 3.8% of the index, this may not be the right time to sell. Colas notes that in 2019, the energy sector was still 5% of the index.

Calculating the undervaluation of energy stocks is straightforward for Colas, as in 2011, the energy sector weighting in the S&P 500 was almost three times its current index representation, at 11.3%, when energy prices were similar. "What else do you need?" he asked.

European equities are being demolished, and investors should focus on hedging risk in the U.S. energy market, particularly in energy stocks, as the case for U.S. energy isn't solely based on oil prices.

In this market climate, Colas believes that energy stocks are the key to success for investors.

Energy shorts have reached their highest level since 2020, but the details show that the big bets against "wildcat"-style drillers are more likely in other energy niches, including renewable energy spots like EV charging and in the coal sector, rather than among the biggest oil and gas producers. In fact, the biggest U.S. oil companies had less short interest than the S&P 500 as a whole.

Avoid the error of shorting a new high as a rookie analyst, advised Colas.

Oil stocks are cheap and good dividend payers, with a maximum price of $130," he stated. "We rarely observe more than a 100% return, but oil stocks are a great investment.