Oil Prices May Not Drop, Even If There Is A Recession

By Tsvetana Paraskova

• A growing number of economists are warning that a recession could be on the horizon.
• A recession will surely impact oil demand, but it could just weaken its growth, not lead to an annual decline in global demand.
• For oil demand to actually contract, a recession has to be severe, and the Fed is optimistic that the U.S. will have a soft landing.

As a growing number of economists and Wall Street bankers warn that a recession is coming later this year or next year, another camp of analysts says that a recession—even if it did occur—may not be as severe a hit to global oil demand and prices as the COVID-inflicted crash or the 2008 recession.    The Fed is raising interest rates, and annual inflation in most of the developed economies is at the highest it’s been for four decades. The Russian invasion of Ukraine is also depressing the economic outlook for Europe, while food prices globally are soaring as the two rivals in the war are major exporters of agricultural commodities. Russia is also a major exporter of energy commodities. The combination of all these factors have analysts and bankers concerned that it’s only a matter of time before a recession hits the economy, considering that the Fed is signaling numerous key interest rate hikes to combat the highest inflation in 40 years.

The questions here are: Will the Fed succeed in bringing down inflation without causing a recession? Or, in case of a recession, how hard will global oil demand be hit?

According to Bloomberg Opinion columnist Javier Blas, the chances are that there would be a milder recession like the ones from 1990 and 2001 rather than the 2008 recession. A recession, even a milder one, will surely impact oil demand, but it could just weaken its growth, not lead to an annual decline in global demand, Blas argues.

If that is the case, oil demand may not crash and oil prices may not collapse, at least not as much as the bears believe.

Like many predictions in the past two years, these also hinge on major unknowns, including how China will recover from the COVID restrictions of the past weeks, how long and how fiercely the war in Ukraine will drag on, or whether Russia will just one day decide to cut off gas supply to the whole of Europe, causing an immediate economic downturn.

As high energy prices and record-high diesel prices impact every part of the economy, the fight against inflation becomes more complicated for monetary policymakers, including the Fed, as steeper interest rate hikes could lead to the deterioration of economic activity and household spending and, ultimately, recession.

Fed Optimistic It Could Engineer “A Softish Landing”

The Fed believes it currently has good chances for the U.S. economy to have a “soft landing”.

“Now, I would say I think we have a good chance to have a soft or softish landing or outcome, if you will,” Fed Chair Jerome Powell said early this month when the Fed announced the single largest interest rate hike in more than two decades, raising the key rate by 0.50 percentage point.

There are several reasons for a “soft landing,” including households and businesses in strong financial shape, excess savings on balance sheets, and a “very, very strong” labor market.

“And so it doesn’t seem to be anywhere close to a downturn. Therefore the economy is strong, and is well positioned to handle tighter monetary policy,” the Fed’s chair said.

The task is challenging, Powell admitted, but reiterated this week his confidence that the Fed could bring inflation down without tanking the economy.

“It is challenging because unemployment is very low already and because inflation is very high,” Powell said this week in an interview during The Wall Street Journal’s Future of Everything Festival.

Wall Street Fears Recession

In recent weeks, investor concerns about a recession have intensified, leading to sell-offs in the stock market. On Wednesday, the Dow Jones Industrial Average had its worst day since 2020 after major retailers announced quarterly earnings hit by supply chain issues and rising costs.

Although the odds of a recession are now higher than they were two months ago, the base-case scenario of investment banks is slowing growth but not an outright recession.

Goldman Sachs, for example, revised down this week its U.S. economic growth forecast to 2.4% this year on an annual basis, down from 2.6% growth previously expected, and to 1.6% in 2023, down from 2.2%.

“We now think the rate hikes that are currently priced into financial conditions are in the ballpark of what is ultimately needed to restore balance to the labor market and cool wage and price pressures,” Goldman Sachs economists wrote in a report on May 15.

Slower economic growth will likely slow down global oil demand growth if the Fed manages the “soft landing” successfully. For oil demand to actually contract, a recession has to be severe.

Last month, Goldman Sachs said the U.S. economy would likely avoid a contraction because “households are in better shape financially than they have been at the onset of most recessions.”

Goldman Sachs economists think there are roughly 15% odds of a recession in the next 12 months and 35% within the next 24 months.

By Tsvetana Paraskova for Oilprice.com