On Inversions and the Price of Oil

On Inversions and the Price of Oil

by | published August 16th, 2019

Crude oil prices were showing signs of stabilizing this morning after one of the more volatile weeks in recent memory. Much of this instability resulted from ongoing concerns about global demand, themselves in turn fueled by angst over a worldwide recession.

As I have noted here in Oil & Energy Investor on several previous occasions, that view is based more on sentiment than anything else.

The tangible data justifying it is a full six months into the future. Prior to the numbers hitting, this is all fodder for speculators to run short moves in a true Chicken Little “The Sky is Falling” motif.

Nonetheless, it does have an effect and the rising concerns of a global slowdown do have an impact in how much oil analysts believe the world economies will require.

Of course, the next geopolitical tension blowup or transport interruption promptly causes the pendulum t swing in thither direction. For a bit, supply overcomes demand as the target of attention and prices spike back up.

One thing is certain. Any approach regarding the energy sector as independent from other considerations is as artificial as a three-dollar bill.

However, another aspect of the “impending recession doom” view hit this week and resulted in an immediate downward pricing pressure on oil.

This is the bond yield inversion.

Chicken Little Rises when the Yield Curve Inverts

Bond yields are the interest providers must pay to entice purchase and are an essential indicator of perceived risk. These fixed instrument yields one counter to price. That is, as yields increase, the price that can be attracted for the bond declines.

But over the past week, something occurred that pundits called the latest indicator of an international recession…

The yield curve inverted.

In normal times (do we even have these anymore?) the longer a bond has before it matures, the higher the yield. That translates into higher risk consideration because the instrument is in the market for a period of time.

In the U.S. treasury market – the one in which investors are trading bonds (having a maturity of ten years or more), notes (two to ten), and bills (a year or less) issued by the government – 30-year paper should have a higher yield than 10-year, which should have a higher yield than two-year.

When an inversion on the yield curve occurs, with shorter-term paper having a higher yield than longer-term, it telegraphs a market concern that risk is perceived as more likely sooner rather than later.

And that leads to an immediate (and largely self-proclaimed) prophecy of recessionary doom with all of its attendant financial “fire and brimstone.”

This sanguine view is buttressed by the observation that each of the last seven recessions in U.S. history was preceded by a bond yield curve inversion.

Well last week, the yield on two-year notes spiked above the yield on 10-year bonds, a phenomenon that has not hit since 2007.

Immediately, prognosticators flooded the airwaves proclaiming the next recession was upon us.

Let Us Not Panic about a Biblical Recession

There are three matters to remember in all of this hype.

First, while the last seven recessions have been preceded by an inversion, there have been more yield curve inversions over the past four decades that did not produce a recession. In other words, just because all bananas are yellow, it does not follow that all yellow things are bananas (I had a yellow car once that turned out to be a lemon, but that’s another story).

Second, even if a recession does take place after an inversion it usually takes 18 months to more than two years for it to show up. Yes, the stock market has had an incredible run and a pullback is inevitable, but that does not mean it is coming anytime soon.

Third, the market we have these days had marked differences from the one around during previous recessions. That last protracted recession was signaled on 2007, hitting in 2008-2009.

At that time, the yield inversion was ushered in by an accelerating collapse in collateral debt obligations fueled by the implosion in sub-prime mortgage pyramid schemes and their infection of wider dollar-denominated paper.

Nonetheless, when an inversion occurs it immediately attracts attention. And given the other perceived signals (all anecdotal) of a global slowdown, it will impact on oil prices.

The rule of thumb applied here by the pundits is to say the slower economic performance the less energy is required to fuel it.

Well, here are two caveats to all of this when it comes to investing in energy.

First, another truism points toward demand elasticity. That says that the lower energy prices move, the more demand is generated. That generally translates into providing a floor under medium-term energy demand expectations.

Second, as subscribers to my Energy Advantage, Energy Inner Circle, and Micro Energy Trader services well know, making money in energy is no longer dependent upon the price commanded by a raw material.

Oh yes, one final observation: the inversion corrected itself yesterday and the price of oil is moving back up as of this morning.

So, let us sit back and watch as things play out.



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