Ameriprise Financial Price of Oil and Equity Markets: How Interconnected are They?
In February oil began to rally as talk of a production freeze first surfaced. Equity markets rose in response, wiping out a 10 percent drop in prices to start the year. But the rally in both stocks and oil was also accompanied by widespread skepticism that a production freeze would have much of an actual impact. Since the market remained oversupplied, what was really needed was a production cut, and that was not likely as major producers fought for market share.
There was also the question of verification in light of a history of production exceeding quotas among OPEC members. But there was some hope that a freeze could buy time for rising global demand to eventually eliminate the oversupply, while supporting prices that would generate higher revenues in the meantime. Once the Saudis insisted upon Iranian participation, the freeze was doomed. Iran has only recently been freed from international sanctions that crippled its oil production, and is ramping back up quickly. It never had any intention, therefore, to agree to a freeze.
Furthermore, Iran and Saudi Arabia are rivals for influence in the Middle East, making it next to impossible for them to agree on a course of action that was clearly not mutually beneficial, at least not in the short run. Perhaps Iran might have been more amenable had its production already reached its eventual target, since its fiscal coffers have also been depleted, but not now.
Where Does the Price of Oil go From Here?
The immediate question for investors is where does the price of oil go now and how do equity markets respond? West Texas Intermediate crude closed on Friday at \\$40.36 a barrel. In early trading on Monday it fell as low as \\$37.64, down almost 7 percent. However, it recovered quickly, and was trading back up at \\$39.65. It is too early to say where it eventually settles. Some energy market observers have warned that prices could retest their mid-February lows near \\$26 a barrel. Others are not as pessimistic. The rebalancing of the global market has been ongoing, despite the two-month price rally.
Baker Hughes reports that currently there are 440 active oil and gas rigs in the U.S. One year ago that total was 954. According to the U.S. Energy Information Agency, U.S. oil production peaked last June at a daily rate of 9.61 million barrels when the price was just over \\$60 a barrel. During the week of April 8 of this year, the daily rate had dropped to 8.98 million barrels.
In its April oil market report, the International Energy Agency estimates that global oil demand will continue to grow this year by 1.2 million barrels a day, well above the projected growth in production of 0.5 million barrels. This would represent a sharp turnaround from 2015 when consumption grew by 1.3 million barrels a day, but production grew by 2.5 million. That would still leave the world market oversupplied, but the gap is projected to steadily narrow and be completely eliminated by the middle of 2017. In the absence of a production freeze, the process of market rebalancing should be accomplished more quickly than otherwise.
How Might Equities Respond?
Two other developments since the February trough in oil process argue against a repeat of the acute weakness in equities. First, the dollar has weakened as the Federal Reserve has lowered its outlook for the pace of future rate hikes, taking pressure off commodity prices and U.S. manufacturing. Second, widespread fears of a global recession have retreated in response to recently better economic data in the U.S. and China, the International Monetary Fund’s lower projection for global growth notwithstanding.
This is not to say that the outlook for equity prices is not without its issues. Earnings remain challenged, despite lowered expectations. And economic growth is not exactly robust. Politics, at home and abroad, are no doubt having a chilling effect on economic decision making. The weekend impeachment vote in Brazil is just the latest example. But where the price of oil settles, and whether it reasserts its influence over equity prices remains to be seen.
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