Something strange is going on: movements in equities have been unusually highly correlated with moves in the oil price over the past few months. Both oil and stockmarkets have fallen sharply so far this year.
We need to be careful how we read this: correlations between many assets have risen, as they often do at times of investor stress – it’s not just equities and oil. And we all know that correlation is not the same as causation – we can’t simply state that oil is driving equities, much though it may feel that way. Still, the association between moves in the oil price and moves in equity markets is unusually strong right now and has come to dominate investor attention.
Many commentators seem to be making a connection between low oil prices and demand from oil consumers around the world. Oil prices have collapsed from over US$100 a barrel in late 2014 to around US$30 now: surely a fall of that scale means that demand has collapsed and the global economy is in trouble?
It’s a frightening story, but fortunately one with no basis. Markets may remain very prone to recession scares, but they’ll need to look elsewhere for evidence of one: the world’s consumption of oil has been amazingly steady in recent years, growing at 1-2% a year since the Global Financial Crisis (with China in particular showing continuing growth in demand for oil and refined oil products). While it’s not yet clear what 2016 will bring, there is no problem with global demand for oil. Indeed according to the International Energy Agency (IEA) “2015 saw one of the highest volume increases in global oil demand this century”.
So why the price weakness? If it’s not about a shortfall of demand, perhaps there is an excess of supply? This looks like a much more plausible explanation. It doesn’t fit the global slowdown story that the market wants to believe at the moment, but, much more importantly, it does fit the facts!
GROWTH IN OIL PRODUCTION VS GROWTH IN OIL CONSUMPTION
Source: Thompson Reuters Datastream
Normally, there is a fairly strong relationship between oil production and consumption, with both growing steadily and at a similar rate over time. At times of slowdown or recession (as in 2008), oil consumption falls and producers tend to respond by cutting supply. However the last two years or so have seen extraordinary conditions, as US shale oil has hit the market and the Organization of the Petroleum Exporting Countries (OPEC) has maintained supply in the face of deep price falls: the upshot – oil production has been growing significantly above demand, for a sustained period.
Let’s put this supply glut in context: there have been brief episodes where global oil supply has grown ahead of demand over the last decade or so, but we have seen nothing like this sustained imbalance in the market since the late 1990s (when we also witnessed sharp falls in the price of oil).
GLOBAL OIL CONSUMPTION MINUS GLOBAL OIL PRODUCTION
As a result of excess oil production, oil inventories are running at unusually high levels. In the US, commercial crude oil inventories are at 30 year highs, despite the resumption of oil exports to Europe and Asia for the first time since the 1970s.
An excess of supply over demand can be resolved in one of two ways: either through continued growth in demand, which looks highly probable as the global economy continues to expand, but may be a rather slow way to bring the market back into balance; or through curbs in supply.
Historically, we have been used to geo-political tensions in the Gulf, Nigeria, Russia or elsewhere
causing higher oil prices as markets worried about supply interruptions. Political instability or conflict is always possible – arguably, with fiscal stresses on oil-producing nations intensified by low oil prices, political risk may be even higher than usual – but it’s possible that abundant oil inventories in the developed world could limit the impact of such events. We may need to see a significant and sustained reduction in oil supply for prices to stabilise. Commercial oil producers are constrained from large supply cuts due to their need to keep generating cashflow (even at a loss!) in order to service interest on debt. The ball is firmly in the court of OPEC and the large state-operated enterprises. We make no forecast on what OPEC may or may not do – the politics, conflicting priorities and hidden agendas are opaque – but simply note that we are sceptical of any meaningful or sustained rebound in oil prices until production has fallen enough to work through the high levels of inventory.
This might suggest a cautious stance on equities too, given the strong recent association between oil prices and equity moves: if we can’t believe in the foundations of any oil price rebound, how can we see through the recent pessimism on equity markets?
On the contrary: while investors are looking for evidence of recession in low oil prices, experience suggests a diametrically opposite view is more reasonable! While some global stock markets have quite a high exposure to energy and other resource companies (The UK, with Shell, BP and BG accounting for over 12% of the FTSE 100 market cap, stands out on this front), a strong direct link between oil and equities makes less sense for other markets. The US (where energy company profits account for less than 5% of total S&P500 earnings) and Japan (where the energy sector accounts for about 1% of the market). The recent correlation between oil prices and equity markets looks unjustified and should fade, or even reverse, when investors lose their misplaced anxiety over falling oil prices and refocus on fundamentals.
OIL PRICES DOWN MORE THAN 50%: MARKETS UNDERESTIMATING THE UPSIDE RISK TO GROWTH IN US, JAPAN AND EUROPE
Deutsche Bank economists show this relationship clearly (see chart on the left). There is a lag of around 18 months between cause and effect but when oil prices fall sharply (i.e. when the blue line rises in the chart), we have always seen global GDP growth rise sharply in the aftermath. Why should we expect this time to be different?
The driver of stronger growth is obvious. Lower oil prices mean a clear benefit for consumers, with cheaper fuel and heating resulting in a direct boost to disposable income. Citigroup estimate that American families are on average US$900 a year better off thanks to cheap energy.
Some of that will be saved but some will be spent, perhaps especially among lower income groups. Over time, the relationship between disposable income and household spending has been reasonably close, as one might expect (see chart on the right). In fact real personal consumption expenditures in the US are growing and are now around their highest levels since the financial crisis. Should we expect it to be different this year – at a time of healthy job creation and falling unemployment in the US?
A strong US consumer provides a strong driver of growth not only for the US, but for companies and economies around the world exporting goods and services to meet this demand. The most obvious pocket of strength today may be evident in US services industries, but we’d be wary of arguments that suggest consumers’ demand for more ‘stuff’ has somehow been sated.
US CONSUMPTION IS GROWING – US REAL DISPOSABLE INCOME AND SPENDING (YOY%)
Is it possible that weakness elsewhere in the economy could undermine the strong consumer? Anything is possible, but we can’t find evidence for this, and the numbers suggest it’s unlikely, given that consumption is by far the major part of the US economy – indeed all developed economies. Energy-related capital expenditure (Capex) has been a drag for the last year or so, as producers have looked to slash costs and protect profit margins: it’s roughly halved in the US, from about 1% of GDP to 0.5% of GDP in 2015. At that size, though, even a (further) complete collapse has limited capacity to hurt the overall economy. Moreover, it is dwarfed by other aspects of capital spending, which remain in reasonable health: IT-related capex, for example, accounts for about 4% of US GDP.
What about manufacturing? We have heard much about the woes of the US manufacturing sector, facing twin headwinds of a strong Dollar (making exports less competitive) and capex cuts in the oil industry. That’s a tough environment, and energy-related sectors of manufacturing are indeed dragging down the whole, so that US industrial production volumes are broadly flat-lining overall. But other key sectors remain in reasonable shape: production volumes related to durable goods, motor vehicles and construction continue to grow. And while investors’ focus can often be dominated by manufacturing-related data, thanks in part to the abundance of statistics on the sector, we shouldn’t forget that manufacturing is dwarfed by services in developed economies.
While there will be painful regional effects in job markets in oil-producing districts (and knock-on effects on local services and housing markets) – in Texas and North Dakota in the US, in Aberdeen in the UK – we should be careful not to extrapolate the threats to oil-economy jobs to paint a misguided picture for the whole economy. The energy sector accounts for just over 1% of jobs in the US: even catastrophic cuts would seem unlikely to undermine a pretty healthy labour market, with an average of more than 200,000 jobs a month created last year and an acceleration in the last quarter. Against such a backdrop, consumer confidence could well remain buoyant.
What about the vulnerabilities from debt in the energy sector? Oil companies have been significant borrowers as they built up production capacity. A steep fall in revenues as oil prices have collapsed will hurt many players, particularly the most leveraged borrowers, and defaults will undoubtedly rise. This has led to a significant sell-off already in US high yield bonds (where energy companies account for over 15% of debt). With the scars of 2008 fresh in the mind, investors are terrified of another Credit Crunch: could the oil sector be the epicentre of another 2008 system-wide risk event? Again, it seems unlikely: while a few regional banks have high exposure, and there will be local failures, the big banks simply don’t have enough exposure to the sector for bad loans to be a problem. Energy accounts for about 2.5% of Bank of America’s loan book, about 2% of Wells Fargo and less for JPMorgan.
Many of these loans are to less-indebted ‘investment grade’ companies and may be unlikely to fail, but even if they do after years of rebuilding, bank capital buffers are far superior now compared to 2008. And while it seems extraordinary to us here in the UK, with our banking system concentrated in the hands of a few big names, we really shouldn’t be alarmed by the failures of small regional banks in the highly-fragmented US banking system. It’s a surprisingly regular event. According to the US Federal Deposit Insurance Corporation, over 50 failed in 2012, 24 in 2013, 18 in 2014 and 8 last year – with barely a headline or a ripple beyond the immediate area. After a painful period in markets, it’s very tempting to succumb to the pessimistic narrative swirling around markets, but our process demands a clear analysis of the real risks and the opportunities, versus what is priced into market valuations. If we thought the world was going into recession, our portfolios would look very different – but we don’t. It seems to us that markets are wrong: isn’t it time we stopped worrying and learned to love cheap oil?
This Article is from Alex Scott, Deputy Chief Investment Officer at 7IM, one of our investment managers.