As we have seen twice in the past week, sudden, sharp falls in the oil price produces sharp rises on Wall Street (especially in airline shares).
Sharp rebounds see markets swoon, and when added to financial worries, it’s a double swoon.
When, as we saw Wednesday night there’s a sharp fall in oil and a hint of good news from a bank, American investors rejoice: ignoring the reality of a sharp rise in inflation. That was repeated again on Thursday night as oil fell further to be more than 10% down from its all time closing highs. It finished just under $US130 a barrel in New York.
The AMP’s Dr Shane Oliver says that the oil price is now critical to the outlook for shares.
While the long term trend in the oil price will likely remain up, current prices are not justified by oil supply and demand and are likely to fall back – probably to around $US100 a barrel – in the next 6 months.
But he warns that if the oil price continues to surge shares will remain under pressure. Iran and hurricanes are the wildcards.
Oil is the key
The big slump in shares from their highs in October/November last year to their lows in March this year was driven primarily by the credit crunch.
But the continued surge in the oil price has played a major role in the slump in shares since mid-May which has now taken them below their March lows.
The dramatic rise in oil prices is now a major threat to economic growth.
It has also made the credit crunch worse by pushing up inflation and hence market interest rates which has offset the US Federal Reserve’s interest rate cuts, made global central banks more hawkish, and increased the risk of debt defaults.
While US Treasury moves to support Fannie Mae and Freddie Mac should help provide a bounce for shares, if the oil price doesn’t turn around soon a global recession will become a certainty and shares will fall further. But if the oil price does manage to stabilise and start heading back to earth then shares will likely be given a huge boost.
Fundamentals support a rising trend in oil price
For many years our view has been that the rise in oil prices has been justified by fundamental supply and demand considerations.
As countries like China & India industrialise (and in the process use up more energy) the supply of oil is struggling to keep up.
For China and India, their per capita oil usage has been rapidly rising, but even though this has been occurring from a low base the huge population of both countries has meant a massive rise in oil demand, with China now accounting for around 70% of the annual increase in global oil demand.
And this is set to continue. E.g., if per capita oil consumption in China and India were to rise to just half of Australian levels it would imply an extra 40 million barrels per day in global oil demand (which is currently 86 million barrels a day). At the same time the sources of cheap easily extractable oil are drying up.
As a result the long term trend in the oil price is being driven by demand and supply factors and will remain up.
But has it become a bubble in the short term?
Over the last six to 12 months the rise in the oil price has become exponential, even though the supply and demand situation hasn’t really changed that much.
This suggests it may be starting to run ahead of fundamentals. Speculative manias tend to have several key elements:
•Easy money and low interest rates;
•A fundamental dislocation which underpins initial price gains and provides enthusiasm for the eventual mania;
•A means to allow mass speculation; and
•The extrapolation of past price gains into the future.
Many of these are now arguably present in the case of oil.
•The cut in US interest rates has provided the easy money backdrop and the associated fall in the $US has increased demand for commodities as a hedge against dollar weakness. Falling share markets have also encouraged investment flows into commodities.
•The China story and all the talk about “Peak Oil” has helped provide a fundamental justification.
•The advent of commodity funds investing into futures has provided a means to easily invest in commodities.
•These have up to 74% benchmark weights in energy.
•Analysts have been falling over themselves trying to come up with ever higher predictions for the oil price. Expectations of $US150 to $US200 are now common.
Certainly, the surge in the oil price is starting to look like past bubbles such as the bubble in Japanese shares in the late 1980s and the tech bubble in the late 1990s, i.e. prices rise steadily for many years justified by fundamentals only to then start rising exponentially. (See the next chart).
Of course, the argument that the surge in the oil price has become speculative has been subject to much debate.
Some have argued that it’s hard to find definitive proof of speculative involvement.
Measures of speculative positioning in oil and sentiment are mixed.
But then again it’s always hard to prove that price surges are due to speculative bubbles.
Secondly, it’s been argued that there can’t really be a speculative mania in oil because if there were then demand would dry up, production would surge and stockpiles would go through the roof burning the speculators and this hasn’t happened.
However, against this it may be the case that demand is just responding with a long lag. Supply growth may be struggling to keep up with demand but the situation has not chang
