Further acceleration of production growth from non-OPEC suppliers, specifically from the resurgent U.S. shale sector, or a hiccup in global demand will be far bigger threats to the price of oil than the current volatility roiling equity markets.
That premise may be difficult for some observers to accept given that crude oil prices and equity prices have increasingly moved in tandem in recent years – breaking their traditional inverse correlation – and this week’s price action only serves to reinforce the idea that crude and equity markets are closely linked.
The international Brent benchmark price slipped below $65 a barrel this week, marking a 6.8% decline since the start of February. The move lower coincided with a similarly sharp move in the SPX Index, which declined 8.5% over the same time period.
So are equity markets pulling crude markets lower?
The correction in the stock markets appears to be less about concerns over economic growth – which would be troubling for oil demand – and more about frothy equity valuations, fear of rising interest rates and a vicious unwinding of short volatility trades.
Of those three factors, the biggest risk to oil prices is the rising interest rate scenario, which could boost the value of the U.S. dollar. A stronger dollar would have negative implications for oil prices and that may be the biggest concern for energy investors to take away from the recent market turmoil.
Oil has an inverse relationship to the dollar, as a stronger U.S. currency makes it more expensive for non-U.S. investors to buy dollar-denominated assets such as crude. President Trump has said he wants to see a strong dollar but Treasury Secretary Steven Mnuchin suggested a weaker dollar is “good for trade” after the greenback hit its lowest point since 2014. The administration’s internal debate over the dollar’s strength should be watched closely.
As for other factors currently weighing on stock markets, the events of the last week could prove to be just a blip. The major banks don’t appear overly worried and remain sanguine about the impact of the sell-off on oil prices. Goldman Sachs still sees Brent reaching $75 over the next three months and climbing to $82.50 within six months. JP Morgan recently raised its 2018 forecast for Brent to $70.
A closer look at oil markets shows supply-demand fundamentals holding steady, with Saudi Arabia and Russia committed to a deal to cut 1.8 million barrels a day in production involving OPEC and non-OPEC producers set to run through the end of this year and possibly beyond.
Growth in U.S. shale oil output remains a wild card, but oil demand forecasts remain strong. The U.S. Energy Information Administration (EIA) just pegged demand growth at 1.73 million barrels a day this year and noted that improved global economic growth expectations could be supporting oil prices. Indeed, the International Monetary Fund recently forecast that world Gross Domestic Product would grow by 3.9% in both 2018 and 2019, rates that are both 0.2 percentage points higher than previously forecast.
More evidence of oil’s insulation from the roiling equity market can be seen in the forward price curve for crude, which remains firmly in a state of backwardation, with prompt oil priced at a premium to later deliveries – an indication that traders see tighter markets ahead.
While increased financial speculation played a part in crude’s recent rally to $70, firming fundamentals – as well as heightened geopolitical risk – have been much bigger factors. And those support structures are not showing any sign of weakening, which means chaos in equity markets doesn’t necessarily mean a plunge in oil prices. Despite crude’s recent pullback, it remains in positive territory for 2018.