If the $2.7 trillion global crude oil market were a sovereign country, it would be the world’s eighth-largest economy, right after France. “Black gold” is the most-traded commodity in the world. And oil influences every part of modern life — from transportation to clothing to the extraction of the metals needed for decarbonization.
Because oil pervades the economy, it’s a key influencer in the inflation that’s been hitting household budgets and corporate bottom lines. The high inflation rate has prompted the Federal Reserve to raise interest rates, which are reducing the acceleration of price increases but have also raised worries that the U.S. will enter a recession.
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The inflationary and recessionary outlook and how investors position themselves for those possibilities got a little more complicated as of April 2, when OPEC+, a group of nations including OPEC and its allies, announced oil output cuts totaling 1.66 million barrels per day. That’s on top of an existing cut of 2 million barrels per day through the end of 2023.
That leaves stock market investors to weigh several intertwined forces when it comes to potentially adjusting their portfolios.
On the one hand, the output cut will support the price of oil, which has been declining since its Ukraine-war high but is still well elevated by pre-pandemic standards. That means inflation may stick around longer than previously expected, even if the rate of inflation continues to subside. It also throws into question assumptions about the Fed’s easing up on interest rate increases.
“OPEC+ likely wants to avoid a U.S. recession, something that would ultimately destroy demand. It is looking for a Goldilocks situation where the price is not too high, nor too low, but just right.” – Justin Zacks, vice president of strategy for Moomoo Technologies
At the same time, an overly hawkish Fed — not to mention a full-blown banking crisis, if one were to emerge — could tip the U.S. economy into a recession, which ultimately would cause oil prices and the cost of other goods and services to come down.
Oil-stock investors over the past year have seen the only gains out of the 11 S&P 500 sectors. But that outperformance has been fading as oil prices have fallen from about $120 a barrel last year to around $80, as traders worry about how inflation and the Fed’s reaction to it might hurt the economy and demand for oil. More recently, banking industry problems have weighed on crude prices.
Oil did get a bump after the OPEC+ announcement, but gains have been limited as weaker-than-expected U.S. employment and services data have indicated that economic growth may be slower.
All this raises questions about whether it’s time for investors to rotate more into defensive stocks or inflation hedges and what the timing, if any, of such a move should look like:
— How will OPEC+ cuts affect oil and gas prices?
— How will oil output cuts influence the Fed’s actions?
— How would higher oil prices impact the economy?
— Will oil production cuts lead to recession?
— Should investors brace themselves or sit tight?
[READ: 10 Best Energy Stocks to Buy in 2023]
How Will OPEC+ Cuts Affect Oil and Gas Prices?
Peter Earle, an economist at the libertarian-leaning American Institute for Economic Research, says it’s hard to know what the intermediate-term price effect of the extra cuts will be because many economies are contracting right now.
“If the most developed nations of the world enter a recession in the second half of this year, the effect of lower demand may render the price impact minimal,” he says.
At the same time, James Hill, CEO of natural gas exploration company MCF Energy Ltd. (ticker: MCFNF), notes that the cutback comes at the same time that China is coming out of its COVID-19 lockdown and increasing competition for energy supplies.
“The production cuts will have a positive price impact on the price of both oil and natural gas,” he says.
How Will Oil Output Cuts Influence the Fed’s Actions?
With oil prices around $80 per barrel, the Federal Reserve may continue to worry about services and wage inflation rather than goods inflation caused in part by oil prices, says Justin Zacks, vice president of strategy at online trading platform Moomoo Technologies Inc.
That could change if the supply cut is accompanied by higher demand that begins to boost oil prices markedly. A substantial increase in oil prices back to last year’s highs could prompt the Fed to become more aggressive in its contractionary campaign, Earle says.
How Would Higher Oil Prices Impact the Economy?
“But that decision will be tempered by how quickly the U.S. economy is contracting and whether or not the mini-banking crisis of a few weeks ago appears to be over,” Earle adds. “The likelihood of more rate hikes coming depends pivotally upon how much oil prices rise, and for how long they stay elevated.”
Higher oil prices could complicate the Fed’s efforts to manage inflation, leaving central bankers to weigh a return to a more hawkish stance against potential damage to the economy, says Saqib Iqbal, an analyst with financial education website Trading.biz.
“There is a possibility that the oil output reduction may keep inflation high enough to warrant more rate hikes and potentially tip the U.S. into a recession.” – Saqib Iqbal, analyst at Trading.biz
On the flip side of the coin, Hill says the banking crisis is likely to cause the Fed to ease up on its rate hikes, despite pressure to raise rates as oil prices rise and boost the costs of other commodities and food.
“The ability of the Fed to continue to fight inflation with rate increases will continue to negatively impact the financial system,” Hill says. “This means we are between a rock and a hard place in trying to control inflation.”
[SEE: 7 Stocks That Are Good Inflation Investments]
Will Oil Output Cuts Lead to Recession?
If oil prices were to move substantially higher, they could prove to be a tipping point for the U.S. economy, which has already been seeing slowing economic growth because of higher interest rates, Earle says. The potential resulting recession could happen whether there are more rate hikes or not, he says.
“There is a possibility that the oil output reduction may keep inflation high enough to warrant more rate hikes and potentially tip the U.S. into a recession,” Iqbal says.
At the same time, OPEC+ might agree to increase output again to lower oil prices in an effort to avoid a recession in the world’s largest economy.
“OPEC+ likely also wants to avoid a U.S. recession, something that would ultimately destroy demand,” Zacks says. “It is looking for a Goldilocks situation where the price is not too high, nor too low, but just right — a stable price where they can make a good profit for an extended period of time.”
Should Investors Brace Themselves or Sit Tight?
Uncertain economic outlooks such as these are why experts say investors should have diversified portfolios. Broadly, a classically diversified portfolio would have 60% stocks and 40% bonds and include a wide range of asset classes, world regions, industries, company sizes and investment styles.
Within those types of portfolios, more active investors may want to shift some holdings slightly depending on whether they see inflation or recession as the bigger threat.
Utilities, consumer staples and health care are often considered defensive stocks that will hold their value better than other types of equities during economic downturns because people need electricity, toothpaste and medicine regardless of what the economy is doing.
“Some level of inflation is likely here to stay for a while. That means that a portfolio mix that includes assets that perform well during periods of price increases could be valuable.” – Justin Zacks, vice president of strategy for Moomoo Technologies
But they’re not necessarily the best plays for inflationary periods, which at a rate of about 6% in the U.S. can’t be ignored.
Inflationary hedges include gold and other commodities; Treasury inflation-protected securities, or TIPS; and real estate.
One caution, according to Earle, is that many inflation hedges have the most potency when they are in place before the general price level begins to rise.
While financial stocks historically do well during inflationary periods, some experts advise that the current industry malaise means investors probably don’t want to increase their exposure to banks.
“We had been in a near-zero inflationary regime for so long that many investors shed all their inflation hedges,” Zacks says. “While the rate of inflation has decreased significantly, inflation has proven to be sticky historically, and some level of inflation is likely here to stay for a while. That means that a portfolio mix that includes assets that perform well during periods of price increases could be valuable.”
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What OPEC+ Oil Production Cuts Mean for Investors originally appeared on usnews.com