Why the oil price rebound could be the catalyst for a stockmarket crash

published 18 January 2018

180118-oil-price-b — Opec failed to kill off US shale oil production

With global economic growth strong and everyone in an optimistic mood all of a sudden, oil prices continue to make a steady recovery from the depths of the 2014 crash.

One obvious question is will a flood of US shale oil kill the rally stone dead?

But the oil price crash and rebound could have far greater significance beyond oil production alone.

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How Opec helped to create an American energy superpower

When oil cartel Opec decided not to resist the crashing oil price back in 2014, the key goal was to wipe out the competition. US shale oil producers were getting too big for their boots, and Opec hoped that a collapse in oil prices would also mean a collapse in the shale industry.

The idea was that low-cost producers such as Saudi Arabia could hunker down and watch their enemies go bust one by one. It's a bit like a supermarket price war: slash prices, boost your market share at the expense of profits, then rebuild afterwards.

It didn't work. It might have succeeded at any earlier date, but US shale was by that point simply too well developed to kill off.

A combination of necessity, forgiving creditors, better drilling technology and good old cost-cutting meant that shale producers weathered the storm and managed to drive down their average cost of production.

Better yet, the price crash created enough political leverage to enable the US oil industry to overturn a ban on exporting oil that had been in place since the 1970s (and which, ironically, came about as a result of previous Opec machinations).

As a result, America now exports around 1.7 million barrels of crude oil a day, according to Reuters. And US oil imports have dropped by about a fifth over the last decade, taking away a significant chunk of the market for its rival exporters.

Meanwhile, the huge quantities of shale gas mean that the price of natural gas for domestic users has dropped by more than a third from its peak in 2008. (Imagine that, eh, UK readers? Falling household energy bills!)

In turn, that's been good for the environment, because, while shale gas is still a fossil fuel, it's displaced coal, which is a much dirtier fossil fuel.

With a scary new competitor in the global oil market, and unrest at home as budget cuts bit hard, Saudi Arabia had to beat a retreat. So now a Saudi-led Opec, alongside Russia, has cut back its own oil production in order to prop up prices. Which of course, are now at a level which is more than comfortable for the shale producers.

So, in effect, rather than wiping out their dangerous new rival, Opec managed to accelerate its evolution into a global energy superpower.

Nicely done.

So where are we now? US oil production is already expected to rise to ten million barrels a day "as soon as next month", notes Bloomberg. That's comparable to Saudi Arabia's current production (which could probably do 12 million a day if it wanted to) and only a million barrels below Russia's average production in 2017.

In short, during a period in which most eyes have been on the financial crisis, America really has struck gold in energy terms, and the resulting transformation in the global energy picture is still in the process of being revealed.

Whatever happens next to oil prices, it's going to get complicated

There are a couple of big questions right now.

With oil now at around $70 a barrel (Brent) and roughly $64 on the WTI measure, there's every incentive for US shale producers to pump as much as they possibly can. So is the oil price really likely to stay at current levels? Or will it come crashing back down?

The second question is: what kind of impact will oil at these levels have on the rest of the global economy? Oil is a key input price some people still blame its surge to more than $130 a barrel for the 2008 crash so it's an important one to watch.

On the first point no one can predict the future, but oil price forecasts tend to be even more hilarious than most. For a start, there are too many moving parts. What will Opec do? How fast is China growing? Are electric cars over-hyped or under-estimated? And even if you get the fundamentals right, a lot of the market is driven by sentiment.

As a rule of thumb, what seems to happen is that oil price analysts gently move their targets up or down behind the current spot price. But once they get cocky enough to start making big calls on future prices "$20 oil!" or "$200 oil!", then it's time to watch for the turn. At the moment, we're still in the "gently moving up behind the spot price" phase. So probably not enough exuberance to worry about a major turn yet.

It's the second question the knock-on effects of oil at these levels that's more interesting. This morning, I was reading a piece of research on the impact of oil price crashes and rebounds on monetary policy and inflation.

Oil price crashes are tricky, because they tend to fool central banks who already have a bias towards fearing deflation. When the oil price crashes, it is disinflationary. Overall, prices get cheaper. But it's not deflationary. Because for most of us, spending less money on oil means we have more money to spend on other things.

In other words, the impact of falling prices masks it at the time, but a drop in the oil price ultimately stimulates the economy (assuming you're an oil consumer, which most developed nations are). Yet central banks, frightened of deflation, will keep monetary policy loose. So you get stimulation both from the falling oil price and from loose policy.

So that makes the rebound even trickier. A rebounding oil price looks inflationary. And even as the oil price is rebounding and headline inflation is rising, at the same time, the stimulation from the previous oil price crash is still boosting the economy.

The central bank sees an overheating situation, and ends up having to raise interest rates more rapidly than it would otherwise have done (over-reacts, in other words), and you tend to get a sharp reaction in the markets as a result.

With today's equity markets so thoroughly over-valued, it wouldn't take much of a surprise on the tightening front to trigger a nasty correction if not more.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.