Oil’s furious descent in the past six weeks has shaken traders and sown seeds of doubt in the minds of investors: If demand for the economy’s most important fuel is weakening, what does that say about the economy itself?
Crude oil futures have slid 26% since Oct. 3, falling to $56.46 from a high of $76.41. By Tuesday, the futures had closed in negative territory for 12 consecutive sessions, a record. Brent crude, the global benchmark, has fallen 23% since Oct. 3, to $66.76.
That kind of volatility can be a red flag for the rest of the economy. When oil swings higher—as it did for much of the year—and then falls precipitously, the economy is often in the midst of a recession.
Oil volatility in 2007 “was not the cause of the financial crisis, but it was certainly a signal that things were not right,” says Will Rhind, chief executive of GraniteShares, which offers commodity exchange-traded funds.
This time, that isn’t the case. By almost every measure, the U.S. economy is humming along nicely, recording its best two-quarter GDP growth rate in four years. The global economy likewise is forecast by the World Bank to continue to expand by at least 3% this year and next year.
And yet there’s no doubt that investors are worried about contagion. Energy is not the only market sneezing today.
Indeed, 2018 is “shaping up to be the worst year on record in terms of breadth of negative asset returns in dollar terms, with data going back to 1901,” according to Deutsche Bank, which found that 89% of asset classes are down in dollars this year. “There has been literally no place to hide,” Peter Boockvar, chief investment officer at Bleakley Financial Group, wrote in an email to Barron’s. “I think there are legitimate worries about the demand side, with global economic growth slowing down.”
Global economic expansion is expected to decelerate in the coming years, and the U.S.-China trade tensions loom large. If 25% U.S. tariffs on $200 billion in Chinese goods go into effect on Jan. 1, growth expectations are likely to be sharply lowered.
The retreat in oil, which recovered some lost ground on the last three days of the week, is not a reason to panic, however. Yes, economists are fretting about global growth and tariffs. But most of the move in oil prices can be attributed to supply growth and geopolitics, not the global economy.
“It was not a change in fundamentals, so much as it was a change in perception,” says Ed Morse, a Citigroup analyst who has correctly predicted several oil moves over the past five years.
Morse says commodity traders were betting earlier this fall on a roaring bull market for crude. Some traders and analysts had predicted that oil would once again test the $100 level. The furor topped out in early October, with long positions outnumbering short positions by about 14 to 1, well above the usual 5 to 1 ratio, Morse notes.
“I don’t think there’s any doubt that financial market participants were largely responsible for the increase in oil prices, and for the rout,” he says. “People went short. They did it very rapidly.”
If the initial drop in October was based on market dynamics, it was exacerbated this month by President Donald Trump’s decision to grant several major oil importers—including China—exemptions from the sanctions on Iran.
Traders had been anticipating that Iranian exports would tumble once the sanctions went into effect, but the exemptions blunted the expected supply drop. Higher supply tends to lead to lower prices.
Any sudden change in asset prices is bound to cause jitters in the market. But similar drops have occurred before, and very few of those declines lasted.
Nicholas Colas of Datatrek Research tracked 14 instances since 2000 in which oil prices dropped more than 20% in 20 days—as they did in the 20 trading days through Tuesday—and found that prices rose, on average, by 1.9% in the following 20 days. The five notable exceptions came during the 2008 financial crisis and in 2014, during an oil rout that sent prices down more than 70%. Those periods seem considerably different from today.
“Look for oil to settle out here as a sign the recent decline is just a reset of supply expectations,” Colas wrote in a note about his analysis.
Absent another price drop, stock investors should have little to fear from contagion, because the correlation between stock and oil prices is weak, he adds. “Oil prices are more focused on industry-specific supply sentiment, while stocks are wrestling with interest rates and peak earnings chatter.”
Morse expects Brent oil, now at $67, to end the year at $78 and trade at an average price of $70 next year. That relative weakness next year will be caused by more supply coming on the market, rather than demand weakness, he says. And he doesn’t anticipate oil prices forecasting problems in the broader economy.
“I think the price will be more reflective of GDP, rather than being indicative of where GDP is going,” Morse says.
The biggest wild card to these forecasts is the OPEC meeting scheduled for Dec. 6 in Vienna. Saudi Arabia has indicated that it will support a reduction in output, though the size of that cut will be a crucial determinant.
“OPEC won’t know what it is doing until the first week of December,” Morse says. “It will depend on what the price is that week.”
|For more news you can use to help guide your financial life, visit our Insights page.|