Summary

• Cold weather causes price volatility in crude oil.
• The inventory cycle, as expected, is fueling a strong business cycle.
• Crude oil has been rising since the business cycle signaled solid economic growth.

My article “A Strong Economy And Easier Lending Standards Are Fueling The Bull Market” published on February 16, 2021, reviewed data showing the economy is strong and will stay strong.

The main theme of the article was the fact business decisions cause business cycles to rise and fall. The most important of these decisions is the management of inventory levels to meet changes in demand. When sales grow faster than inventories, business is forced to increase production to replenish them in order not to lose sales.

To do so they must buy raw materials – thus placing upward pressure on commodity prices. They must hire more people in manufacturing – thus causing employment and wages to improve. They must borrow more to finance working capital and make improvements to the manufacturing process – thus placing upward pressure on interest rates.

The business cycle starts to slow down because of slower demand. Business is eventually forced to reduce production to avoid unnecessary and costly inventory accumulation. They will reduce purchases of raw materials – thus placing downward pressure on commodity prices. They will reduce the workforce to cut costs – thus causing unemployment to rise and wages to grow more slowly. They will borrow less to finance and improve their operations – thus placing downward pressure on interest rates.

The important trend – as reviewed in the above article – was a visible decline in the inventory to sales ratio caused by sales rising faster than inventories. As suggested in the article, business had to increase production to replenish inventories due to strong sales.

On 2/17, following the publication of my article, the Fed released the latest data on industrial production. It showed industrial production rose a sharp 0.9% m/m. The above chart shows the continued improvement in production as expected in the article. Business must keep producing aggressively to replenish inventories.

In my article “Commodities And Stock Prices - It's All About The Business Cycle”, I also explained why the trend of the business cycle and commodities are closely linked.

The above graph shows the relationship between the business cycle and crude oil. Crude oil prices, like other commodities, follow closely the turning point of the business cycle.

This pattern reflects the powerful forces unleashed by the business cycle. They move major commodities from lumber, to copper, to crude oil. Traders do not cause the trend of a commodity. The trend is produced by long-lasting business decisions about the need to change inventory levels. Cold or warm weather, cartels, trading disputes, supply-chain disruptions more often than not create “noise” around the main price trend. The real trend is caused by the business cycle.

The change in the price of crude oil, like that of many other commodities, has an impact on the performance of a company mining or transforming that commodity.

It should come as no surprise, therefore, to see the price of an energy company such as Exxon (XOM) follow closely the rising and declining trends of the business cycle and crude oil.

The above chart shows the graph of XOM (upper panel) and the Peter Dag business cycle indicator (lower panel), updated in each issue of The Peter Dag Portfolio Strategy and Management on peterdag.com.

The graphs of XOM are quite similar to that of crude oil. Its turning points, as for crude oil, correspond to the turning points of the business cycle and industrial production (see also first chart).

As shown in the above chart, the pattern of the price of Chevron (CVX) is also similar to that of XOM and crude oil.

Important takeaways

There is no question cold weather and extreme climate conditions - as those experienced in Texas - have an impact on commodity prices and crude oil in particular.

The above relationships, however, suggest the business cycle is the predominant force behind the main trends and turning points of crude oil and energy stocks.

They also show the best time to own energy stocks such as XOM and CVX is when the business cycle is on an upswing.