The oil price has soared this year – and it’s nothing to do with supply or demand

Oil wells in Russia © Getty Images
Russia and Saudi Arabia would quite like oil to trade at higher prices

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After a grim 2018, stockmarkets have had a pretty decent start to this year.

For example, the S&P 500 is up around 10%. The FTSE 100 is up about 7%. Even Germany’s DAX index – for all the talk of eurozone gloom – is up nearly 7%.

Yet there’s one asset that has blown them all away.

Oil.

Oil has been a better bet than stocks so far this year

The oil price (as measured by Brent crude, the European benchmark) is up by around 20% so far this year, far outstripping the gains seen by developed world stock markets. Oil is now trading near a three-month high.

After last year’s steady decline, it’s good news for the oil bulls. And there are plenty of fundamental reasons to justify it, it seems.

Firstly, we have the ongoing collapse of the Venezuelan economy. That plus new sanctions on the country have hit the supply of oil coming from that direction.

Secondly, Russia and Saudi Arabia apparently would rather have oil trade at higher prices rather than sell more barrels. The cartel known as Opec+ has decided to cut output by 1.2 million barrels of oil per day. Production in January fell to 30.8 million barrels of oil a day, from 31.6 million in December. And Saudi Arabia says it will cut even more in March.

Goldman Sachs has, in typical hyperbolic fashion, described these as “shock and awe” cuts that look set to drive the oil price higher this quarter.

Third, on the demand side, data showed that China’s imports of oil rose by more than expected. And investors are feeling upbeat again about the outcome on the China-US trade talks.

All positive for the oil bull arguments.

That said, there are also plenty of ways to make a bearish case right now. And if the oil price had gone down, then maybe those are the facts I’d be highlighting today instead.

For example, Chinese demand might have been higher than expected. But at this price, US shale-oil producers are pumping as fast as they can and, as a result, US crude oil stocks are at their highest since November 2017.

As for optimism on trade talks – the markets are apparently optimistic today, but last week the pessimists had the upper hand. My view is that the trade talks will be a bit like Brexit – full of fudge and brinksmanship, and very prolonged indeed. So the market is going to be experiencing highs and lows like this for a long while, with the actual economic impact probably very hard to judge.

And don’t get us started on the longer term bear arguments. Plastic use is being cut back aggressively now that straws are public enemy number one. Electric cars are just around the corner. If you want to tell a compelling story about stranded assets, it’s really not that difficult.

The stories that we tell ourselves

I’m not saying that fundamentals don’t matter – of course they do. But on a day-to-day basis, the oil price is not typically reacting to the actual number of barrels being produced and consumed. And on different days, different factors will matter more or less.

For a start, being priced in US dollars means that the oil price will tend to slip when the US dollar is strong and vice versa. (This is not a cast-iron correlation – few are – but it’s always worth remembering about any commodity priced in dollars).

Secondly – and I think, most importantly to the environment right now – oil is a “risk-on” asset. When investors are worried about growth, they sell oil. And this process works in reverse too (it’s “reflexive” as George Soros might put it) – when investors see oil fall, they get worried about growth.

Last year, the oil price started to slide hard in October. At that point Brent Crude was trading above $86 a barrel. At the time, the reason seemed pretty simple: at $80-plus, no one had any reason to moderate supply. Everyone from Opec producers to shale explorers was working as hard as they could. In effect, there were plenty of relatively benign reasons for the oil price to fall.

But stockmarkets began to fall at the same time. This was just a week or so after the US central bank, the Federal Reserve, had lauded the strength of the US economy.

What gives? Put simply, oil and stockmarkets were spooked by the same thing – the idea that the Fed really wasn’t going to stop raising interest rates, and also had no plans to end quantitative tightening (QT).

That set up a fresh narrative arc (“narratives” are all the rage at the moment – it’s simply the recognition that humans like stories, and at any given moment, one story about the markets is more dominant than all the rest).

In this particular story, Fed policy was already too tight. The economy must be due a recession. We were heading into a post-tax-cuts earnings downturn. In short, investors decided it was time to pay more attention to bad news than to good news.

And all of that is primarily about the fear of the Fed.

What’s happened this year so far is that the Fed story has changed. Markets are no longer as concerned about the indomitable Jerome Powell, because he has thrown in his hand already.

The big issue now is that – as is often the case in the first quarter of the year – the economic data is looking ropey. We’ve had some weak jobs data. China is opaque as ever, but we know it’s been slowing down.

However, conditions are ripe. The market is already no longer afraid of the Fed. Now you just need some half-decent economic or political data, and we could easily get back to “fear of missing out” (FOMO) mode.

Fundamentals? When you have central banks in charge of credit allocation, they only matter so much I’m afraid.