Watch the oil price closely – it could herald a market rebound

The oil price has fallen along with virtually every other asset. But keep an eye on it, says John Stepek. An upturn could signal a wider market recovery.

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The market was concerned about disruption to Iranian oil supplies
(Image credit: Ali,Mohammadi)

It's always fascinating to see how rapidly markets can skid from believing one thing fervently to believing the precise opposite, with very little apparent need to question the sudden U-turn.

That's what seems to have happened over the past two months. Markets started October with the S&P 500 hitting a fresh high for the year. If anything, overheating was the big worry.

Then it all went wrong. A few weeks later, and suddenly everyone's talking about a slowdown.

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So let's have a closer look at one of the most obvious casualties of this sudden turnaround.

Oil prices.

Markets tell stories to themselves

Oil prices, as measured by Brent crude, hit their highest level since the 2014 crash at the start of October, surging to more than $86 a barrel.

It's now trading at below $65 a barrel. That's quite the hammering. There are all sorts of stories being put about as to why this has happened, and I'll take a look at the more convincing ones in a moment.

But I'd like to have a quick delve into market psychology here first. First, note that oil does tend to move with wider markets. When the mood is "risk on", oil goes up. When the mood is "risk off", oil goes down.

But markets are mysterious places, populated as they are by imperfect human beings. And one of the most important things to remember about markets is that they are, as George Soros puts it, "reflexive".

That's a fancy way of saying that the market isn't just a barometer of public perceptions of the economy it also influences those perceptions.

We tell stories to explain price movements. Some of those stories are more accurate than others. Some of those stories might better reflect the fundamentals, and thus help you to make good decisions about what's likely to happen to markets next. But some of the stories are simply pasted onto the price move after the fact.

In other words, people see the oil price crashing and they start to think: "Hmm, maybe that's because there's too much oil. But maybe it's because there's a big drop-off in demand that we don't know about." And quite often, they'll panic first and worry about the truth later.

This is where we have to remember that the market is still feeling traumatised by 2008. There are many, many people working in the City and on Wall Street whose whole careers have been spent working in the shadow of that collapse.

As a result, investors are still primed to be hypersensitive to deflation. The merest hint and they are ready to batten down the hatches. Whereas they couldn't really give much of a care about inflation, except inasmuch as it might persuade a stubborn Federal Reserve to raise interest rates further than they would like.

So what's my point here?

Well, I'm wondering if the oil price crash which to be honest, looks to me like a perfectly reasonable response to the market getting ahead of itself, and to both shale and Opec producers pumping much more oil than anyone expected has unnerved an already jittery market, and left it jumping at shadows.

There's a convincing argument to say that the oil market is over-supplied

Let's have a quick glance at what's going on in the oil market.

Apparently, Saudi Arabia has been pumping nearly 11 million barrels a day this month, because customers were concerned about disruption to Iranian supplies, reports Bloomberg. That's a record level.

Now, the thing is that oil didn't end up being required, because the US granted waivers to a number of importers of Iranian oil. So that was a large chunk of surplus oil to hit the market.

Bloomberg's Javier Blas also points out that there is now a staggering amount of oil getting ready to flood out of the US shale fields. This summer, US oil production saw its biggest surge in nearly a century in August, the US pumped out nearly 16 million barrels of oil a day. That's more than Russia or Saudi Arabia.

And with the promise that production bottlenecks will be cleared earlier than expected, fracking groups are preparing to drill more holes than ever. By the end of next year, the US might even be a net oil exporter, say some in the industry.

These are all interesting and valid stories. But what I'll also point out to you here is how the sentiment on shale and the accompanying narrative shifts with the oil price too.

When the oil price is high, people start to talk about how shale won't be enough to meet demand. We start to hear all about how shale fields are running out, or are uneconomical. Therefore, the only way is up for oil prices.

Yet when the price is crashing, it seems there is no price at which shale producers will not pump out their oil. Therefore, the only way is down for oil prices.

However, I think it's pretty clear from these stories that the issue in the oil market right now is not a deflationary growth slowdown, but a question of too much supply.

And as I've said many times before, the thing to remember about high oil prices is that they act as a tax on consumer countries. At an economy-wide level, that's less the case now in the US than it was before fracking came along (low oil prices hurt the oil business which is now more important than it was).

But even so, few Americans are going to complain at you if you give them a double-digit cut in their petrol bills in less than a month.

What if markets get surprised on the upside?

So what does this mean for overall markets?

My point is that we shouldn't risk getting too bearish too soon. We've seen a similar fright to this in the past when oil prices crashed and everyone was vaguely worried about China in 2015.

Junk bonds slid back then too understandably. We saw wider jitters about the strength of markets understandably. But it turned out that it really was just a scare.

The big difference today is primarily that the Fed is much less inclined to step in with a comfort blanket for the market. But I think if economic data continues to be half-decent, and we see more upbeat reports from companies, then there's every possibility of a bounce.

Don't get me wrong. I'm a bear by nature. But something about the sudden willingness of every investment banking analyst on the planet to embrace fears about growth and recession, makes me think that we're not quite there yet.

Keep an eye on the oil price. It's low enough now that it might have bottomed, and even if it hasn't, I don't see it getting much lower than $55 to $60. If it stops falling, it'll be very interesting to see what the rest of the market does.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John 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. John joined MoneyWeek in 2005.

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.