Equity markets and oil prices are behaving lately as if they’re glued together. Our analysis suggests that the correlation is unjustified and investors should start thinking about what might happen when they become unstuck.
Recent concerns about the global economy are reasonable. Investors are digesting a complex array of macroeconomic challenges, from China’s slowdown to the Fed’s monetary policy direction. However, it feels like the oil price is dominating market sentiment. In January, return correlations between US stock prices and oil were almost twice the ten-year average (Display).
Will Oil Prices Crush Growth?
Is this an overreaction? That depends on whether you think oil prices are really at the heart of an unfolding economic disaster. To evaluate these concerns, it’s worth taking a step back to assess why oil prices have tumbled over the last 14 months.
Back in September 2014, oil was trading at close to $100 a barrel. In the background, the balance between supply and demand was shifting dramatically. Yet it was widely believed that OPEC would serve as the ultimate backstop and make sure the market was not oversupplied.
Supply Surged on Production Boom
So how did we end up with $30-a-barrel oil today? For perspective, OPEC supplies around 30 million barrels per day of the world’s 93 million barrels of demand. The other 60+ million barrels of production had been growing as a result of massive investment, driven by low interest rates and assumptions that returns on new projects would be highly profitable with the oil price at about $100.
Advanced drilling technologies were another catalyst for new sources of supply. For example, US oil production in October 2015 was 9.3 million barrels per day, up from 5.6 million in October 2010, according to the US Energy Information Administration. That equates to an annualized production growth of more than 10% since 2010. Even in a booming global economy, it would be hard to envision demand growth reaching that pace of supply, in our view.
Demand Depressed by Fuel Efficiency
To compound the issue, vehicle fuel efficiency has been depressing demand. In the US, miles per gallon (MPG) in aggregate peaked at 22 MPG in the late 1980s, and declined through 2005 to under 20 MPG, according to the US Environmental Protection Agency. Since that point, fuel economy has increased to over 24 MPG, an approximate 3% annual gain in fuel efficiency. For perspective, the trailing US 12-month gain in miles driven through November 2015 was 3.6%, so underlying demand was actually fairly strong.
Taken together, these factors underpin the excess supply in today’s oil market. The dynamics of supply and demand differ by country. But from a global perspective, we believe that there is a fundamental oversupply that is still working itself out of the market.
What does this have to do with the economy? Not as much as many people think. Global demand growth in 2015 was 1.7%, according to the OPEC Monthly Oil Market Report, a level that does not portend significant economic weakness. In contrast, global oil consumption contracted during the recession of 2008–2009. And while low oil prices hurt the energy sector, they also have a positive impact on a broader section of the economy, as lower energy bills provide companies with expense savings, and consumers with more disposable income. These factors help explain why recessions have been caused by high oil prices, not low ones, over the last 50 years.
With a deeper understanding of the underlying causes for the oil-price weakness, there just doesn’t seem to be a convincing justification for stocks and oil to move in tandem today, in our view. Of course, it’s impossible to know when this tight correlation will unwind. But since we believe that oil prices and equities will eventually get unhitched, now is the time for investors to hunt for buying opportunities in the equity market.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.