man standing inside inspecting industrial pipes

By Laura Cooper

The rapid fall in crude oil prices is rattling already-volatile financial markets, with investors’ flight from Energy stocks dragging global equity markets lower. Following a rough October, the S&P 500 has risen only 0.7 percent so far in November as a correction in the technology sector has been met by weakness in energy stocks. The MSCI European Energy Index is tracking its worst quarterly performance since 2015, while declines in oil heavyweights in Asia have kept the Hang Seng Index and Shanghai Composite under pressure.

Crude oil prices have plunged deep into bear market territory with West Texas Intermediate (WTI), the U.S. benchmark, falling more than 25 percent from a four-year high on Oct. 3 and recording its longest stretch of daily declines on record. Brent crude, the international benchmark price, recorded a commensurate drop over the same period, falling by around $20 per barrel to touch its lowest level since April.

Growing fears of imbalances in crude oil markets have sent prices tumbling
Price per barrel of crude oil
oil bear market chart 1

WTI price benchmark

Brent price benchmark

Source - RBC Wealth Management, Bloomberg; data through 11/15/18

Fear over fundamentals

Growing fears of softer oil demand are coming from a weaker global growth backdrop, which, alongside indications of an oversupplied oil market, have sent benchmark prices tumbling. A lack of commitment from OPEC and its allies to curb production at their recent meeting further aggravated the selloff; WTI recorded its largest one-day drop since 2014, falling 7 percent to slip below $55 for the first time since December 2017. The move contributed to one of the largest five-day drops on record, of 21 percent, which sent technical indicators deep into oversold extremes and investor sentiment plummeting to multi-year lows.

The extent of the selloff appears difficult to reconcile with energy market fundamentals. RBC Capital Markets sees scope for crude oil prices to recover.

Clawing back from a bear market

Economic indicators pointing to a deceleration in global growth are feeding investor concerns that global commodity demand could wane. Data in China, Japan, and Europe have softened recently.

At the same time, signs that higher volumes of crude oil could outpace the expansion of demand have exacerbated price pressures. Rising U.S. shale production has propelled domestic supplies to record levels while Saudi Arabia and Russia, the world’s other largest producers, ramped up production in recent months to make up for any Iranian barrels that could be pulled from the market due to renewed U.S. sanctions. But the Trump administration’s recent decision to grant temporary sanction waivers for select countries that import Iranian oil has compounded fears of a market glut.

A weaker global growth backdrop is raising concerns of softer oil demand
Purchasing Managers’ Indexes for the manufacturing sector
oil bear market chart 2

Developed Markets PMI

JPMorgan Global PMI

Emerging Markets PMI

Source - RBC Wealth Management, Bloomberg; data through 10/31/18

Signs of intervention by major oil producers to bring price relief, which could limit further downside in crude oil prices, are growing. Amid the accelerating crude oil selloff, some OPEC members expressed a willingness to curtail supply in advance of the organization’s Dec. meeting. Russia hasn’t yet tipped its hand, but has consistently expressed the importance of partnering with OPEC to steady the oil market.

The world’s largest oil producers have ramped up production
Million barrels per day
oil bear market chart 3

U.S.

Saudi Arabia

Russia

OPEC ex. Saudi Arabia

Source - RBC Wealth Management, U.S. Department of Energy, Bloomberg; data through 10/31/18

With balance in the crude oil market crucially dependent on Saudi Arabia, the country’s recent vow to do “whatever it takes” to contain price weakness further points to a price recovery, in our view. This steadfast approach should remain despite escalating pressure from the Trump administration to maintain current elevated production levels to ensure prices remain low.

RBC Capital Markets, LLC Commodity Strategist Michael Tran maintains a constructive outlook for prices, arguing that the magnitude of the pullback is not warranted by current market fundamentals. Iranian sanctions could ultimately spur a more material supply pullback, especially as the temporary exemptions expire. Meanwhile, Saudi Arabia could quickly turn off its production taps, and heightened geopolitical tensions could limit the degree of imbalance in the market.

On the demand side, with China accounting for 35 percent of total global oil consumption growth since 2010, a domestic economic slowdown is dampening prospects for global oil demand. Even so, Tran sees bright spots in Chinese demand because the economy is more dependent on gasoline for autos than ever before, and that demand is sticky. Also, surging air travel is a key demand component, and the most underappreciated, according to Tran. Finally, the gradual feed-through of fiscal stimulus should support the economy and crude oil demand over time.

Maintaining constructive outlook

The speed of the drop in crude oil prices is exacerbating already-fragile market nerves in the wake of last month’s equity market correction; however, the price downturn pales in comparison to that seen in mid-2014 when the downdraft fuelled a profit recession in the S&P 500.

If anything, recent shifts in the oil market could provide tailwinds to overall equity market performance. Notably, the alleviation of headline inflation pressures from the price drop could temper fears of the need for aggressive Federal Reserve tightening. Market expectations for future hikes have slipped since the oil price correction.

Concerns dominating the largely healthy fundamentals should reverse course and bring relief to the crude oil market, in our view. RBC Capital Markets sees scope for crude oil prices to trend higher with its latest forecasts targeting WTI breaking above $75 per barrel and Brent climbing to $85 per barrel by year-end 2019.


Required disclosures

Non-U.S. Analyst Disclosure: Laura Cooper, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (U.K.) Limited; contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.