is the current equity selloff about oil?

I’m postponing my 2015 Strategy summary/conclusion on Monday.

 

The price of oil has been steadily declining since June  It’s now below $60 a barrel, after having moved sideways at around $100 from January through early July.

I think the drop is being caused by the fact that supply and demand for petroleum are relatively inflexible in the short term, so small changes in either can cause surprisingly large changes in price.  In 2008, for example, the oil price quickly spiked up from $100 to almost $150 a barrel.   It moved above $125 for a short period in 2011 and again in 2012.

Unlike the prior three surges–caused by fears of supply disruption–the current decline is being created by the steady increase in shale oil output from the US.  In a sense, no one needs all the oil now being brought to the surface.  No one has a place to store the excess.  No producer is willing to cut back his lifting to make room for the extra.  The only mechanism available to clear the market is that the price drops until it reaches a level where buyers are willing to take the risk of increasing their inventories.   Doubtless, commodities speculators of all stripes have been accentuating the downward trend with their shorting activity.

Bad as the price drop has been for oil-producing countries–Russia, the Middle East and Africa–it’s a big plus for the rest of the world.    …yet stock markets are falling on the news.  Why?

–Some market strategists are saying that falling oil prices are being caused by a mysterious–and as yet unseen in other data–falloff in economic activity.  In other words, lower oil is supposedly a harbinger of recession.  Other than for the oil producers, this makes no conceptual sense.  And it flies in the face, at least in the case of the US, of all the economic data we’re seeing–which indicate that the economy is accelerating.

–Others argue that falling oil presages deflation, presumably of the type that has plagued Japan for decades.  Again, other than for oil producers and their banks, I don’t see the problem.  Ex oil companies, no one is going to have less money to spend or to use to repay debt.

–There is a stock market-specific issue, though.  Take the US as an example.  In rough terms, the country produces 13 million barrels of oil a day and uses 20 million.  So it imports 7 million.  The price fall means the country as a whole is keeping about $100 billion a year that was previously going to foreign pil producers.  The loss to domestic producers/gain to domestic consumers is about $200 billion a year.  That money isn’t leaving the country.  It’s just going into different pockets.

In an $18 trillion economy, the whole thing is peanuts, even with secondary effects.

But oil stocks represent 8%+ of the S&P 500 (for the MSCI Global index the proportion is about the same).  So the effect on stocks is much more dramatic.

Energy stocks went down by 10% last month   …and they’ve declined another 5% so far in December.  This has two influences on the market.  The drop in oil stocks themselves depresses the index.  In addition, short-term traders, thinking oil shares look cheap (rightly or wrongly), will short other sectors to buy the oils in the expectation of a bounce.  This arbitrage activity drags the rest of the index down as well.  This is just the way stocks work.

–The fact that we’re close to the end of the year, when many professionals have begun closing down for the year, doesn’t help.  They’ll prefer to sit on the sidelines for now and hunt for bargains in January.

my take

I think the “expert” opinions about possible deflation and recession are silly.  The outsized representation of oils in stock market indices is an issue, but a temporary and minor one, in my opinion.  If anything, I think the oil price fall is a trigger for investors to begin discounting potentially higher interest rates next year.  Some investors may simply be taking profits after a 2014 that has been much stronger than anyone expected.  But declines in December seem to me to imply a better chance of gains in 2015.

 

3 responses

  1. I am not an expert in oil. But I just wondering why almost no one in the street had expected the decline in oil price? I would think estimating additions to oil supply are easy work of surveying… Thx

    • Right to the heart of the matter. The simplest answer is that Wall Street expected Saudi Arabia, which is currently producing 10+ million barrels of oil daily, would reduce its output by enough to bring supply and demand into balance–thereby preventing prices from falling. That hasn’t happened. In fact, it appears that the Saudis have been raising production instead.

      I spent six years as a buy-side (i.e., investment managment company) oil analyst a long time ago. I found then that oil–or any other global natural resources business–was a very complex subject that was not well understood by most professional investors. I also found sell-side (brokerage house) analysts to be not very impressive, and heavily dependent on information fed to them by the big oil companies. I imagine this is still the case.

      Another example of how real-life securities markets are not as efficient as academics dream they are.

  2. Regarding oil prices, take a look at today’s WSJ (12/13/2014) front page article. Oil demand fell in developing countries due to: 1) reduced government subsidies, rising dollar, softening economies.

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