Oil Shock Triggers Demand Collapse, Not Inflation

Geopolitical Tensions Spark Energy Crisis, But Data Points Away from 1970s Inflation Scenario

Recent escalations in the Strait of Hormuz have led to a dramatic 35% surge in oil prices within a week, with five tankers reportedly hit and 150 ships stranded. Iran’s threats to target vessels transiting the critical waterway have prompted insurance companies to withdraw coverage, effectively shutting down this vital shipping lane. This crisis extends beyond oil, impacting other energy sources like Qatar’s LNG, with South Korea facing potential gas shortages within nine days. The ripple effects are already being felt across global supply chains, with fertilizer prices up 30% and jet fuel soaring by 52%. The pervasive integration of oil in manufacturing, packaging, and transportation means these price hikes are baked into nearly every consumer product.

While the dramatic surge in oil prices has drawn comparisons to the inflationary 1970s, historical data and current economic conditions suggest a different outcome. In the 1970s, oil prices quadrupled, leading to rampant inflation averaging 7-13% annually and a significant erosion of savings. However, the primary driver of that sustained inflation was not solely oil, but a massive increase in the M2 money supply, which grew by 154% over the decade. This expansion, fueled by aggressive bank lending, kept pace with rising costs, maintaining consumer demand and allowing inflation to persist.

Oil’s Limited Inflationary Impact

Analysis of 65 years of data reveals that oil’s direct contribution to inflation, as measured by the Consumer Price Index (CPI), is significantly lower than commonly perceived. While oil and energy constitute about 7% of the CPI basket, they contribute only around 9% to its overall movement. Historical charts show a correlation between oil price fluctuations and CPI, but it is not overwhelmingly strong, with the relationship being inconsistent month-to-month. This suggests that oil price spikes, in isolation, are not the primary inflationary force they are often made out to be.

Money Supply: The Real Inflation Driver

In stark contrast to the 1970s, the current M2 money supply has grown by only about 3% in the last four years. Furthermore, consumer savings are at historic lows, with many individuals depleting retirement funds to cover essential expenses. This precarious financial position means consumers lack the purchasing power to absorb rising costs. Unlike the 1970s, where wage growth kept pace with inflation, enabling continued demand, today’s consumers are already stretched thin. This lack of purchasing power is a critical factor differentiating the current economic environment from the inflationary spiral of the past.

Demand Destruction and Economic Slowdown

The current oil price shock, occurring in an environment of tight credit and depleted consumer savings, is more likely to trigger demand destruction rather than sustained inflation. As the costs of essentials like fuel and food rise, consumers are forced to cut back on discretionary spending. This reduced demand can lead to businesses freezing hiring or even initiating layoffs, impacting the labor market. Recent non-farm payroll data, showing the worst job losses since the pandemic, indicates that the labor market is already weakening. This economic damage can ultimately lead to a collapse in oil prices, as seen in past instances where oil spikes preceded economic downturns and recessions.

Historical precedents support this outlook. In 2008, a surge in oil prices to $147 per barrel contributed to a collapse in demand and a subsequent crash to $30, coinciding with the global financial crisis. Similarly, in 1990, an oil price increase following events in Kuwait tipped an already weak economy into recession. These episodes demonstrate that geopolitical oil spikes, when not accompanied by significant money printing, tend to result in reduced demand and economic contraction.

Impact on Cryptocurrencies and Liquidity

For the cryptocurrency market, the key determinant of price movement is not oil prices or inflation narratives, but global liquidity. Data from Michael Howell’s Global Liquidity Index suggests a 65-month cycle for liquidity flows. Having recently passed a peak in October, liquidity is expected to decline, impacting risk assets like Bitcoin. Historically, Bitcoin tends to lead these liquidity cycles, peaking and declining earlier, but the current trend indicates continued strain. Charts show a strong correlation between global liquidity and major cryptocurrencies such as Bitcoin, Ethereum, and Solana, underscoring the importance of liquidity for crypto asset performance.

In the short term, Bitcoin is likely to face headwinds as liquidity tightens. The narrative of declining liquidity suggests that rallies may be met with selling pressure. However, the long-term thesis for Bitcoin, particularly as a hedge against potential future currency debasement, remains intact. In times of crisis, hard assets like gold often perform well, and while bonds may hold steady, risk assets such as equities and cryptocurrencies could experience further weakness. The current market environment, characterized by tight liquidity and reduced consumer spending power, points towards a period of consolidation or decline for risk assets, rather than a significant upward trend in the immediate future.

Source: Oil Is About to Destroy Bitcoin (65 Years of Proof) (YouTube)