Return correlations in January were almost twice the historical average. In November 2014, oil was trading at close to $100/barrel, and while the supply/demand balance was getting skewed, most believed that OPEC would serve as the ultimate backstop, making sure that the market wasn’t oversupplied. So one has to ask, how did we get to where we are today, with oil at $30/barrel? For some perspective, OPEC supplies approximately 1/3 of the 93 million barrels a day of demand worldwide. The OPEC supply of 30 million barrels a day has not fluctuated immensely since November 2014. However, production of the other 60+ million barrels has been growing as a result of significant investment, given the low interest rates and attractive returns assuming a $100 price floor. The application of advanced drilling technological enhancements was also a factor in bringing on additional supply. Using the US as an example, oil production in October 2015 was 9.3 million barrels per day, which has increased by 40% since October 2010. It’s hard to envision demand growth equaling that advance in any kind of economic environment. Compounding the oversupply issue, fuel efficiencies have caused there to be a lack of demand for oil in recent years. In the US, miles per gallon (mpg) peaked at 22 in the late 1980s; whist current figures show it to be 25, an approximate 3% gain in fuel efficiency.

While each country will have different supply/demand specifics, the fundamental oversupply in the oil market has largely been driven by excess supply, and fuel efficiency has led the moderation in demand. Nevertheless, according to OPECs Monthly Oil Market Report, global demand growth in 2015 was 1.7%- one that signals much optimism in the current economic climate. The correlation between equity and oil prices are at exponential levels we have not seen in recent times; in a recent publication Citigroup have particularly highlighted the equity markets of Japan, the Eurozone and the emerging world are showing near perfect correlation.

According to the International Energy Agency, the oil market will begin to rebalance in 2017, with the US reducing their production rates in the short-term and OPEC’s oil output freeze means we may see a slight decline in oil production. But a combination of diminishing demand for oil globally, and increased oil output production from non-OPEC countries may lead to further volatility in the oil markets in the short and medium term.     

WHAT SHOULD LEAD EQUITIES?

Primarily, core fundamentals should be leading the equity markets- notably earnings. Undoubtedly, earning have been disappointing and will continue to be bleak due to a host of factors; notably a slowing in China’s growth, uncertainty of a Eurozone recovery, Federal Reserve interest rate policy dilemmas & a decline in commodity prices. However, as short-term pessimism eradicates, many investors will seek value in the equity markets and companies will increase their profit margins in due course as stimulating effects of lower oil prices filter through. On a country level, this will be particularly evident for the net importers of oil- notably China, US, Japan & India, which make up half of the worlds $77tn GDP- and their current accounts.

As the world markets move beyond the price of oil, they may start focusing on more fundamental determinants, but as we’ve seen this journey may take longer than expected.

Vickram Grewal

Chair, Young Fabians Finance Network

@VGrewal7