What’s next for global markets? Keep a close eye on the oil price

The price of oil has tumbled in recent weeks, just as stocks have lost their footing. John Stepek looks at what a rebound in crude would mean for investors.

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Alberta, in Canada, has cut production
(Image credit: © 2018 Bloomberg Finance LP)

Global stock markets lost their equilibrium at the start of October.

Interestingly, that's when the oil market hit its highest point since the crash of 2014. Since then, oil has fallen hard, entering a bear market.

The cause and effect is very hard to untangle here. Oil is another "risk-on" market, in that oil prices tend to rise when everyone feels bullish. So oil might be reacting to the wider market slide.

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But it's also true to say that oil is viewed as a key indicator of global demand and inflationary prospects. So a slide in oil prices will often attend a slide in bond yields (which has happened this time around).

So what would a rebound in oil prices mean for investors now?

The big changes in the oil market

The oil market has seen a fair bit of tumult in the last few weeks. With prices sliding hard, those dependent on oil revenues have been under pressure, which has revealed itself in a variety of ways.

Firstly, Qatar quit oil cartel Opec, with a decision to focus on natural gas rather than oil production. In terms of practical impact, it's not a big deal it's the guy on tambourine quitting the band to focus on his solo album, rather than the lead singer. But it was an important indicator of the political impact of Saudi Arabia throwing its weight around even more than usual.

Secondly, Canadian tar sands producers are being told to cut production. The government in the Canadian province of Alberta announced an 8.7% production cut from the start of next year. That's 325,000 barrels of oil a day. Meanwhile, producers are slashing investment plans for next year.

The cuts have come about because there is a lack of pipeline capacity for shifting the oil from Canada to get it to market. That has resulted in the Canadian oil price benchmark (Western Canadian Select) sliding relative to the US benchmark (West Texas Intermediate which is itself a lot lower than the Brent crude price).

The gap ("spread") between Canadian crude and US is always chunky. It's not a benchmark I've ever paid much attention to, but looking back over the past year, the spread between the two has often been around $20 a barrel or more. That's because crude from the tar sands is less desirable than lighter oils. It costs more to refine and it costs more to get it to the refineries.

But in the second half of this year, the spread has exploded as crude stockpiles have built up. At one point in November, the Canadian oil price fell below $15 a barrel, notes Nicholas Kusnetz for the Inside Climate News blog.

The local government isn't keen on that, because it gets royalties from the sale of the oil, and so the plunge in prices has hurt government revenues. So it ideally wants prices to go higher, and it also wants production to hold off until new pipeline projects are completed (although these are being held up by challenges from environmentalists, so may well be delayed further).

And now, the rest of oil cartel Opec has teamed up with Russia to agree to cut production (with the exception of Iran) by 1.2 million barrels a day for the first half of 2019. At this time last week, it didn't look certain that the nations involved would agree a deal, but expectations management is everything with markets, and it seems this is what happened.

It's worth bearing in mind that oil producers don't like cutting production. You do it to drive up prices (or stop them falling). But it means you sell less oil. So it's not a pleasant choice to have to make. So what's driven all this?

A brave new world for oil markets

There are a lot of reasons for the slide in oil prices, but the main one has to be the huge shift in the energy landscape, summed up by one key piece of data.

Last week, the US became a net oil exporter for the first time in nearly 75 years. That's staggering. In 2005, at its peak dependence on foreign oil, the US was importing more than 12 million barrels of oil per day. Now the US produces more than 11 million barrels a day by itself.

This doesn't mean that the US isn't in the market for oil. Refiners still buy plenty of oil from overseas as Javier Blas notes on Bloomberg, the US imports more than seven million barrels a day, much of which it then exports as refined fuel products.

But it's still an incredible change. Oil has always been wielded as a geopolitical weapon that point was amply proven in the 1970s. And the oil market is a huge driver of capital flows around the world "petrodollar" flows are a complex business but they are a key part of the world's financial plumbing. So it's a huge story that America is now the global "swing producer" of oil.

So that's the summary of why prices have been falling, and also how that's affecting various producers around the world.

Of course, the US producers need oil to maintain a certain price as well. As Eoin Treacy points out on FullerTreacyMoney.com, the fact that Canada has been forced to drop out of the market shows that the squeeze on prices is hurting.

There's only so long that this can continue without US producers growing more circumspect about production too.

So now that the squeeze is making itself felt, it does seem likely that oil prices are approaching (or have seen) a bottom again. Brent crude is back above $60 a barrel this morning.

Keep an eye on this. Look for feed-through into the bond markets, as investors assume a rising oil price will be inflationary. If long-term yields can pick up again, and the yield curve can retreat from inversion (which is what everyone was talking about last week), markets might regain their poise.

Particularly if the Federal Reserve decides that discretion is the better part of valour when it comes to raising interest rates again this month.

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.