Low-Energy Fridays: Why are oil prices falling when they’re exempted from tariffs?

This has been a busy week with trade wars and a lot of uncertainty for various commodities.

Most notably for the Low-Energy Fridays audience, oil—despite being exempted from many of the tariffs—fell sharply in price, and still hasn’t fully recovered to last week’s level. The reason for this is simple: Oil investors anticipate lower oil demand under the cloud of a trade war. But this simple explanation also offers some broader economic insight.

There’s a saying in economics that “the stock market has predicted nine out of the last five recessions.” In other words, negative sentiments in the market don’t always relate to more reliable indicators of economic performance. This is because the stock market is fundamentally an exercise in investor sentiment. While supply and demand determine the price of stocks, “futures,” and commodities, the supply side of stocks remains largely fixed while the demand side reflects investors’ positive or negative predictions. High stock prices for Nvidia, for example, reflect investors’ anticipation of artificial intelligence demand more so than product sales.

Oil prices usually reflect “futures,” or the price at which consumers promise to purchase oil. This is why oil prices briefly fell into the negative in 2020—the downward movement reflected production well in excess of demand and producers’ desperation for buyers during the pandemic. Oil prices fall when production goes up, as we saw in 2014 with the fracking boom. Prices also rise or fall when global events, such as the war in Ukraine, disrupt supplies. But in the most recent case (and most times oil prices fall), the anticipation of reduced future demand for oil is to blame.

As the source of most transportation fuels used in the world, oil is generally a base input to economic activity. If economic activity slows, then the demand for oil falls. Oil is also traded in a global market, so events both at home and abroad can majorly impact prices. So, what can we glean from the latest price changes?

As noted above, although investor insight is not the same as the truth, it can still be useful. In this case, the clear message is that investors likely believe three things about the fallout (and rebound) from President Donald J. Trump’s tariffs: First, that tariffs are economically significant enough to reduce the global demand for transportation; second, that they may be protracted enough that purchasing oil at last week’s price is too risky; and third, that the economic fallout will be global. (Remember, oil prices reflect global supply and demand.)

Of course, one might view falling oil prices as good news because of the reduced energy costs. But if the reason for falling oil prices is reduced demand rather than improved productivity, then the relative input costs for economic activity in terms of labor and capital are largely unchanged. Simply, the economic news is bad rather than good because lower prices reflect classic recessionary signals of reduced consumption and production.

Plenty of pundits are talking about the merits and demerits of tariffs. But from an energy policy analysis perspective, falling oil prices in response to a new policy indicate that future economic news will be negative. Ultimately, investors are only correct some of the time. While policymakers should always take oil price changes with a grain of salt, they would be wise not to ignore warning bells that their policies may carry more economic cost than anticipated.