The Fed’s Fight Against Inflation: Is WTI Crude Oil Recession Proof?

Ryan Dusek Written by Ryan Dusek
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The Fed’s Fight Against Inflation: Is WTI Crude Oil Recession Proof?

The Fed’s recent interest rate hike is aimed at combating inflation, but will ancillary factors affecting WTI crude oil demand and prices add fuel to the fire?

How quickly things have changed. Just a year ago, the Federal Open Market Committee (FOMC) gave a picturesque view of the economy. Any inflation was transitory and would likely fall to 2% in 2022. The federal funds rate would remain lower longer with little chance of a recession.

At that same time, we had a different point of view. Given the weak U.S. dollar (USD), cheap money, and the U.S. Federal Reserve’s (the Fed) oversized balance sheet, it was inevitable that inflation would occur. Now, with the highest inflation rate since the early 1980s, the FOMC is playing catch up with one of the fastest Fed funds rate increases on record. On September 21, 2022, the Fed raised its interest rate by 75 basis points for the third time this year to a 3.00-3.25% range and signaled more large increases to come.

U.S. inflation is at 8.3%, the highest rate since the early 1980s. Source: Bloomberg
The Dollar Index has started to go parabolic with a target of 120+. Source: Bloomberg

This rapid increase in interest rates will have consequences. As you can see in the chart above, the U.S. dollar currency index (DXY) has continued to strengthen. A stronger U.S. dollar makes dollar-denominated commodities like U.S. benchmark West Texas Intermediate (WTI) crude oil relatively more expensive for holders of other currencies. That being said, U.S. corporations not actively hedging their foreign currency exposure will take a hit in earnings. After continued periods of steady USD decline, this recent interest rate shock is being felt around the world. This new market will test companies’ assumptions about their forex (FX) portfolio, another area that equity and debt investors will need to monitor.

What To Expect From WTI Crude Oil Prices

With the focus shifted to the FOMC, crude oil demand destruction has taken center stage. Inversion of the treasury yield curve (two-year treasury trading higher than 10-year) is a strong indicator of a looming recession. Economic growth has slowed more than estimated and the equity markets continue to struggle with the broader S&P index down 24% year to date. Given the FOMC’s guidance for higher rates over the next four years, we’re barely in the second inning of this game.

Implied Policy Rate – Currently peaks in May 2023 at just over 4.6%. The elevated rates are expected to persist well into 2025. Source: Bloomberg
10-2 Year Treasury Yield Spread – The spread was at -0.41% on September 22, 2022, compared to 1.07% at the same time last year. This is lower than the long-term average of 0.92%. Source: Bloomberg

Although demand destruction is real, the larger issues reside on the supply side. Fundamentally, the energy complex has been under attack. Between politicians wagging fingers and blaming CEOs for higher oil and gas prices and new ESG initiatives impeding new fossil fuel development, U.S. crude production is waning and will likely be slow to respond to any type of supply shortage. Major headwinds include:

  • Government Spending Programs — The deceptively named “Inflation Reduction Act” only adds fuel to the fire. Chasing a carbon-free agenda is expensive and results in higher costs with less reliability. Additionally, providing more stimulus to an already inflated economy will not end well.
  • Restrictive Fossil Fuel Energy Policies — In addition to higher costs, replacing fossil fuels with renewables without established infrastructure creates storage, transmission, and reliability issues, especially in geographies where it’s needed most (e.g., rural America).
  • Strategic Petroleum Reserve (SPR)Depleting the SPR with the largest reserve draws in history is a sure sign that the Biden administration is ignoring the supply side issues.
  • ESG Initiatives —With increased investor and activist pressure to inject ESG programs into their energy portfolios and investments, we’re also limiting supply by avoiding and encouraging less investment into new fossil fuel projects.

At the end of the day, this anti-fossil fuel environment will only exacerbate the diminishing crude supply and continue to promote higher energy prices. Although the stronger U.S. dollar has started to impact the price of crude, I believe we’re closer to the bottom than the top. With crude prices trading as low as $78/bbl on September 23, 2022, the market is primed for a very bullish run. Tight supply coupled with heightened geopolitical tensions concerning the Russia-Ukraine war will likely drive WTI crude oil prices to new highs around $180/bbl.

Winter Is Coming

The scariest part is I don’t believe we have seen peak inflation. By my calculation, the current 8.5% inflation rate will be at least doubled. With a target DXY of 120, we should ultimately peak well above 20%. The highest prices are still on the way. With winter approaching and energy costs expected to double, keeping warm could be an expensive proposition.

Peak Inflation Estimates – This analysis is contingent on the level of the DXY and has an estimated 3-6 month lag time. The currently estimated peak inflation of ~20% should filter through in early 2023. Source: Opportune LLP analytics

About The Expert

Ryan Dusek is a Director in the Commodity Risk Advisory Group at Opportune LLP. His industry experience includes commodity trading, risk management, supply chain optimization, and derivative valuation. He is an expert in developing financial models to quantify complex/uncertain issues and deliver real-world solutions. He has extensive experience in the pricing, hedging, and portfolio management of the natural gas markets. Ryan has led all aspects of commercial deal structuring and pricing for wholesale natural gas trading and origination. He has over 15 years of experience in the energy industry. Ryan has an MBA from the University of Texas at San Antonio where he specialized in Finance.

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