Cracking Up

We saw a major break in the price of several commodities yesterday, with major foodstuffs like corn and wheat down over 4%, and energy products like West Texas crude and gasoline down over 8%.  As we noted at the time, the declines were the result of a convergence of a sharply stronger US dollar and recession fears.  The former meant that fewer dollars were required to purchase a given unit of commodities, the latter meant that demand for some of those commodities would shrink alongside the economy.  Considering that the US Dollar Index rose by just under 1.5%, it is clear that the move was more about demand concerns rather than strictly the currency appreciation.

While the bond market is signaling less recessionary concern than it did yesterday – yields in the 2-30 year range are up 8-9 percentage points – the dollar is continuing its advance and commodities are continuing to decline, though all at a slower pace than yesterday’s.  These moves are providing welcome relief to those fearing runaway inflation.  That said, bear in mind that central bankers, particularly those at the Federal Reserve, prefer to consider measures of core inflation which exclude food and energy.  Any relief from rising food and energy prices will be welcomed by consumers but may not play a significant role with monetary policy makers.

The following chart points out another problem faced by consumers.  While crude oil is a crucially important commodity, it is largely useless in its unrefined state.   Consumers and most industries utilize refined products such as gasoline, heating oil, diesel, jet fuel, and more.  It is unusual in that the most actively traded and followed form of energy is a raw material.  We don’t trade bauxite instead of aluminum, or gold-bearing rocks instead of gold, yet to some extent that is what we do when we trade crude oil.  For the past few months, the price of crude oil has been outpaced by that of gasoline, as the chart below shows:

7 Month Daily Chart, Rolling Front Month Contracts, RBOB Gasoline (RB, red/green), WTI Crude (CL, blue)

Source: Interactive Brokers

The difference between refined products and crude oil is called the “crack spread.”  Refiners buy the crude oil and sell the resulting products to their customers at the prevailing prices for the refined products.  We see that the crack spread for gasoline remained quite stable even as prices rose since late last year.  The rise in the early part of this year was largely the result of an improving economy and greater post-Covid mobility.  Then, Russia invaded Ukraine and oil prices shot higher.  We see that the crack spread remained relatively stable even during that first wave of volatility in March.  It was only later in the spring that gasoline began to far outpace that of crude.  The recent differential is perhaps more evident when we look at the same chart over an 18-month timeframe:

18 Month Daily Chart, Rolling Front Month Contracts, RBOB Gasoline (RB, red/green), WTI Crude (CL, blue)

Source: Interactive Brokers

When we consider how much consumers’ inflationary perceptions are shaped by rising oil prices, it becomes clear why the recent angst is so persistent.  Gasoline prices far outpaced crude and continue that outperformance even as both commodities decline.  Furthermore, prices at the pump are usually slower to fall than those in commodities markets.  On the plus side, some relief may be coming for embattled consumers.  Unfortunately, it might be slow to arrive.

Those who invest in energy stocks need to consider whether the widened crack spread will persist.  If not, it portends relative underperformance for refiners vis-à-vis drillers.  If so, then refiners are likely to offer more profit potential.  In a more macro sense, the decline in energy is likely to provide a bit of a breather for the inflation-wary, but may not be sufficient to change the Fed’s mindset about core inflation and inflationary expectations.

This week’s declines in key commodities are like a rainstorm that breaks a long, uncomfortable heat wave.  Some summer rainstorms are strong and persistent enough to break a drought, others simply provide welcome but temporary relief.  As someone in a profession with a spottier predictive record than meteorology, I’ll offer the suggestion that the scant evidence so far points to more of a welcome relief than a climactic change.