The relationship between oil prices and equities is growing closer

Global equity losses dragged the commodity down with them last month, a phenomenon not often seen

Pump Jacks extract crude oil from oil wells in Texas, United States. Historically, the correlation between stocks and oil has been a relatively weak one. Photo: Bloomberg

December was a rout month for global oil prices, which were dragged down by stock market losses as investors shed equities on recession fears.

The damage extends from earlier in the fourth quarter of 2018 when energy prices plunged 15.4 per cent in November, erasing gains made in the third quarter, according to the World Bank. WTI Crude reached new yearly lows of $42.36 per barrel as of December 24, and Brent Crude was down at around $50 per barrel. Provoking the sell-offs is a clear fundamental imbalance: global supplies of oil appear to outstrip global demand.

So far, January still offers a softer market for oil, with the exception the trade truce between China and the US has heartened investors. OPEC’s December supply cuts are also a support for the commodity.

Nonetheless, bearish factors prevail. Breaking it down, demand from Asia is expected to be lower in 2019 because China’s economy slowed down on the back of a trade war with the US. In America, recession fears were stoked by several red flags, including ongoing stock market losses on fears of a global slowdown; uncertainty over the Federal Reserve’s stance on interest rates and inverted bond yields.

In response to falling Oil prices, Opec promptly reined in production by 1.2 million barrels per day, intervening relatively quickly to stem the commodity’s losses. Nonetheless, Opec’s action was quickly priced in by the market and any support for Brent Crude was offset by the US Shale industry - which is still pumping at record levels.

All these developments have led the EIA to forecast average US production levels of 12.9 million bpd in 2019, meaning Opec just can’t get a break. The World Bank expects US oil production to remain robust in 2019, counterbalancing production losses expected from Opec members Venezuela and Iran. It appears that - as manufacturing slows down in China and doubts rise over the US and EU’s economic performance – the relationship between the oil price and stock exchange benchmarks is drawing closer.

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Historically, the correlation between stocks and oil has been a relatively weak one – except when investors perceive there is softening global aggregate demand based on gross domestic product weaknesses in the larger mature and emerging markets.

It’s not just about perceptions; investors are taking concrete actions to limit their exposures to volatility. Not least on the list of fallouts, Chinese oil traders refuse to buy US crude. In the first seven months of 2018, China imported more US crude than Canada, but the activity tailed off rapidly during the rounds of trade tariffs between the economic behemoths.

More recently, the trade truce between Xi and Trump encouraged Chinese oil trader Unipec to consider restarting its US imports, at least for March delivery while the 90-day truce holds, proving that investor confidence could be restored if the political actors cooperate.

Economic productivity and corporate profits go hand-in-hand. It’s highly likely that as GDP slows and impacts profits, investor confidence towards purchasing raw materials like oil will track the slowdown.

Trade wars between the world’s two largest economies – the US and China – damaged corporate profits, prompting gloomier stock growth forecasts for 2019, feeding into GDP weakness and global demand expectations for oil. The knock-on effects may continue if corporations continue suffering profit losses due to trade tensions and uncertainty over the stability of import-export tax regimes. The bright spot is a softening of tensions between China and the US and the prospect of a trade deal in March 2019, in which case, things could improve for both oil and stocks.

Hussein Sayed is the chief market strategist at FXTM