Not so long ago, when oil was trading at US$140 a barrel, a litre of gas cost as much as a bottle of Perrier. Since then, the collapse in crude oil prices to less than US$30 a barrel combined with stable prices for sparkling water has led to an unexpected turn of events: oil is five times less expensive today than sparkling water.
This amusing fact reported by a major brokerage firm(1) however is no cause of concern for arbitrageurs since the litre of Perrier is not traded on the stock exchange. More disturbing however – not only for arbitrageurs but for the financial community as a whole – is the recent correlation between equity and crude oil prices. When the decline in oil futures accelerates as it did on 20th January, the Dow Jones abandons more than 4% and when oil rises in the evening, equities immediately recover as well. This trading session, exceptional in its magnitude, illustrates well a new phenomena: since the beginning of the year, oil prices have become the independent variable for equity prices.
Over the long term however, the correlation between crude oil prices and equity prices remains low. What is the reason then for this unprecedented connection and above all, why is the decline in oil prices, initially perceived as positive for consumption and growth, now considered negative for equity markets?
One can understand how the sharp drop in oil prices could have adverse consequences for the oil industry and oil- producing countries. CLSA, in a recent study, reported a decline in annual revenue of US$2,400 billion for oil- producing countries and US$400 billion for coal producers… The American energy sector is consequently suffering: 73% of US companies in this sector now have a junk bond rating. The shale gas adventure that gave rise to such hope, is now going through a painful slump. 60% of capacity has been shut down in one year. Continuing this series of mind-boggling figures, the market capitalization of the world’s 10 largest oil and gas companies has shrunk by US$750 billion since the end of 2014.
However, the misfortune of producers is the good fortune of importers. For China, which consumes 7.5 billion barrels per day, a 10% decline in crude oil prices is equivalent to 0.3% of additional growth(2). This same phenomenon applies for India (0.5%) or Indonesia (0.3%). To summarize, even the most pessimistic economists recognize that the net impact overall of inexpensive oil is positive on global economic growth, with the winners considerably outnumbering the losers.
Then what do the markets see that economists have missed? In reality, it is not what they see but rather what they remember: in 2008, the reversal of a single industry sector (namely, real estate) was enough to break the balance sheets of the largest banks, followed by the pace of worldwide growth. Oil and gas industry debt and the bankruptcies to come remind them of the preceding situation of the subprime crisis. In this second scenario, the recession is thus inaugurated by an abandoned oil rig.
However, in adopting this interpretation, markets are committing two errors. The first is one of scale: real estate investments in 2007 represented 6.5% of US GDP whereas the oil and gas sector today accounts for 0.5%. Similarly, real estate related debt represented 70% of GDP in 2007 compared to only 3% for the oil and gas sector today. The second error is one of scope. The subprime crisis was so devastating because virtually everyone held bad debt through structured products. There is no comparison in the case of oil and gas. For that reason the risk of contagion is in this case infinitely small.
The markets do have real reasons to be nervous (see our strategic update). However if the pace of the decline mimics that of the oil and gas sector, then the price of Brent crude oil becomes their guiding star and we will be presented with opportunities, remembering that, as with the example of sparkling water, markets sometimes act crazy.
Didier Le Menestrel
(2) Source: Les Cahiers Verts de l’Economie
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