Crude Oil Is Not Going Out Of Business

Crude oil has of course gone on a wild ride for more than a year and lately, as its volatility has been increasing, the correlation to equities has also increased. When the volatility characteristics of an important market change dramatically it is a signal that something is going on regardless of whether we can figure it out.

The commodity super cycle from the 2000’s was a real phenomenon and it built upon the foundation of China’s growth and modernization. To a lesser extent other emerging markets also contributed to the commodity super cycle.

The more than 2/3rd decline in the price in the last couple of years is in part a deflation story. There is an element of creative destruction (the good kind of deflation) with the shale boom which for now is focused in the US but as Dennis Gartman has said (paraphrasing), the US can’t be the only place in the world to have shale formations. Demand for oil has not kept up with growth in supply which puts downward pressure on the price but it is difficult to believe that the supply/demand dynamic could account for a drop from $100 down to $30. I believe there must also be some sort of expectation for the future contributing to the decline – in terms of less optimistic growth assumptions as the IMF seemingly lowers GDP forecasts on a weekly basis and a petering out of the China Miracle. If demand really shrivels up, then that would obviously be the bad type of deflation.

I think the reason oil and equities have started to correlate in the manner they have is because oil is now viewed as an immediate proxy for economic activity and growth or lack thereof. This won’t be permanent but is an influencing factor for now.

Oil is down 70%-ish from its high a couple of years ago and down much more from when it hit $150 in 2008. The energy sector’s weighting in the S&P 500 has about cut in half to 6.3%, that kind of change in sector weighting doesn’t happen very often. Oil itself cannot go to zero and it is now down dramatically. Something that cannot go to zero and has fallen 70% is closer to the bottom. If lower for longer turns out to be correct then there will be companies that fail or otherwise go out of business shrinking the field, this is the definition of the cure for lower prices is lower prices argument.