Oil prices surge to two-week winning streak as Iran supply fears grip markets
Bloomberg writes: “Iran War Oil ShockThreatens to Unleash Wave of Global Inflation.” To be fair, the article is not as pessimistic as the title suggests. However, the fear that significantly higher, sustained oil prices will unleash a wave of inflation is gaining popularity and merits discussion.
We start with math to address the historical relationship between oil prices and inflation. The graph below, using data since 2005, plots six-month percentage changes in oil prices on the X-axis against six-month percentage changes in the CPI on the Y-axis. Visually, you can see a positive correlation; however, statistically, the relationship is not strong, with an R-squared of only 0.1824. Based on this fleeting relationship, for every 10% increase in oil prices over six months, we should expect the monthly CPI to increase by 0.11, or about 1.38% on an annualized basis.
From an economic perspective its important to appreciate that oil price spikes often act as a tax on consumers. When households spend more filling their gas tanks or paying higher utility bills, they necessarily have less disposable income to spend on other goods and services. As a result, many corporations and businesses see weakening demand for their products, which tends to push prices lower elsewhere in the economy. In other words, while gasoline may temporarily boost headline CPI, it simultaneously suppresses price pressures in large portions of the consumer economy.
Lastly its worth noting that the Fed often looks through temporary, non-economic fluctuations in oil prices. To wit, they often stress the value of core inflation data. Core, by definition, excludes energy and food prices.
Put Protection Can Be Bullish Fodder
Record negative delta put positioning, as is the case in the options market shown below, is a reliable sentiment signal. When traders and investors accumulate puts at this scale, it reflects a widespread desire to hedge against, or bet on, a significant market decline. While it may seem worrisome that there are record bets against the market, the contrarian take is actually positive.
Historically, record negative delta put positioning has tended to coincide with market bottoms rather than the beginning of sustained declines, because it signals that fear is already fully priced into the options market. When everyone who wants protection has already bought it, the marginal seller of puts becomes scarce, premiums become expensive, and the incremental pressure from new hedging activity diminishes. Moreover, when the trades are reversed, they are bullish fodder for the market. In today’s case, if the Iranian situation de-escalates and/or is less severe than expected, the unwinding of that put positioning can become fuel for a sharp rally, as dealers who sold those puts must buy the underlying securities to remain properly hedged.
Bear in mind that the situation in Iran can escalate, and tomorrow’s put positioning may be higher than today’s, which will negatively impact the market.
Oil Price Shocks And GDP
The graph below is important to consider when assessing how higher oil prices might impact the economy. The US economy has gradually become less vulnerable to oil supply shocks than in the past. Energy intensity, or energy consumption per unit of GDP, has steadily declined thanks to a more services-oriented economy, greater energy efficiency, and technological advances. The share of consumer spending going toward energy goods and services is also near an all-time low.
Furthermore, for those comparing today’s situation to the 1970’s oil price shocks, consider that nearly 100% of domestically used oil is produced in the US. In the 1970s, nearly 50% of oil was imported, making our economy much more vulnerable to geopolitical events at the time.
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