Benjamin M. Lavine, CFA, CAIA – CIO 3D Asset Management
As of the time of this writing, major oil-exporter Saudi Arabia, through its state-sponsored oil producer Aramco, announced on March 8 that it would cut most of its official selling prices triggering a major sell-off in oil prices. Specifically, Aramco plans to slash its popular medium crude by $7/barrel to the U.S., by $8/barrel to Northern Europe, and $6/barrel to the Far East. The energy research team at Goldman Sachs believes that “an oil price war unequivocally started this [past] weekend.” Apparently, there has been a fallout in relations between Saudi Arabia and Russia that started in early February when Russia was noncommittal on proposed output curbs by OPEC.
The Saudi cut is being viewed as a breakdown in the Oil Producing Export Countries (OPEC) cartel as major oil-producing countries (including Russia) could not agree to production cuts in the wake of declining energy demand due to the coronavirus outbreak along with the milder winter weather throughout North America. Just last week, Saudi Arabia had signaled that it would reduce exports by 500,000 barrels a day due to declining global demand, primarily demand from China.
At the market open on March 9, the S&P 500 initially plunged 7% as NYMEX crude oil prices dropped ~23% to $32/barrel. Investors flocking to safe-haven assets pushed down the 10-Year U.S. Treasury Yield close to 0.50%.
Similar to our recent update on the coronavirus (here and here), we look to historical market performance following significant ‘macro shocks’ (in this case, prior plunges in oil prices) to lend perspective. Although it is helpful to see how markets have historically performed following prior episodes of oil price plunges, historical analogs need to be tempered as each episode should be seen in its proper context.
With that in mind, we can discuss how chronic market conditions of oversupply have served as a primary catalyst for prior energy market sell-offs, worsened by drops in energy demand during periods of economic contraction. What is interesting is that today’s drop is occurring in a backdrop where global supply/demand appears to be more in balance, although demand is expected to drop due to the coronavirus outbreak.
Figure 1 displays the cumulative performance over the long run with historical oil price plunges annotated in the chart. Figure 2 displays the average subsequent performance of global equities, U.S. fixed income, and risk-based blends of the two (i.e. 60/40) following the five prior plunges in oil prices going back to 12/31/1996 annotated in Figure 1. Based on prior episodes, the near-term period (up to one year) has been historically volatile for equities and beneficial for fixed income as investors interpret plunging energy prices as possibly signaling an impending economic slowdown and deflation. However, equity market volatility tends to settle down over longer periods as clarity around the economic picture emerges following the short-term noise.
Figure 1 – Cumulative Market Performance with Prior Oil Price Plunges
Underlying Data Source: Dimensional WebReturns and Bloomberg. See performance disclosures in the appendix for underlying index constructions and performance measurement.
Figure 2 – Average Period Returns Subsequent to Prior Oil Price Plunges
Underlying Data Source: Dimensional WebReturns. See performance disclosures in the appendix for underlying index constructions and performance measurement periods (a total of five episodes).
There have been five notable oil price plunges over the past two-and-a-half decades going back to 1997, which had significantly contributed to short-term equity market volatility. Although the individual catalysts for prior price drops vary, chronic energy oversupply relative to demand has served as one common denominator (dotted red circles in Figure 3), worsened by drops in global demand, which usually have historically occurred during recessionary periods (gray bar areas in Figure 3).
Figure 3 – Global Oil Markets: Supply versus Demand (Dec 1996 – Jan 2020)
Underlying Data Source: Energy Intelligence Group. Rolling 12-Month Average of Global Supply and Demand (bbl/day) from 12/31/1996 through 1/31/2020.
The first notable drop in oil prices in recent history occurred in 1998 following Russian debt crisis in the fall of 1998 and the 1997 Asian Currency crisis. Readers may also recall that the liquidation of heavily levered Long-Term Capital Management (LTCM) also contributed to significant cross-asset volatility throughout 1998. “Production binge” from oil-exporting countries and private companies served as the proximate cause of the price drop that saw oil prices plunge from $26/barrel at the beginning of 1997 to a low of $11/barrel reached in November 1998. This production binge resulted in chronic oversupply relative to demand that is evident in the first dotted red circle in Figure 3.
The dotted green circle indicates the current global supply/demand balance where the market is in a slight deficit. Keep in mind, we have yet to see the coronavirus impact on energy demand which is expected to drop in the months to come. However, the Saudi price cut comes in the wake of a much more balanced global energy market relative to the five prior price drop episodes. The Saudi price cut can be seen as an anticipation of this drop in demand, as well as a geo-strategic move to hamstring its oil-producing rivals (Russia, Iran, North American fracking). Time will tell whether this drop in energy prices will tip the global economy into contraction, but much of the recent equity market volatility is due to the coronavirus outbreak. While we wait to see what the final impact will be on economic growth and corporate earnings, we believe that the longer-term will drown out near-term uncertainty.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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Appendix – Subsequent Performance of Global Equities, U.S. Fixed Income, and Risk-Based Blends Following Major Oil Price Plunges (December 1996 – February 2020)
Index Construction and Oil Price Plunge Identification/Time-Stamps Disclosures:
Data source: Dimensional WebReturns and Bloomberg unless stated otherwise. All data as of 2/29/2020 unless specified otherwise.
100% Global Equities: MSCI World Index from 12/31/1996 through 11/30/1999 and MSCI All-Country World Index thereafter through 2/29/2020.
100% Fixed Income: Bloomberg Barclays U.S. Government/Credit Index from 12/31/1996 through 2/29/2020.
Risk-Based Blends (80/20, 60/40, 40/60): risk-based blends of the referenced ratios between Global Equities and Fixed Income using the indices listed above. Monthly rebalance of the percentage weights.
Oil price plunge periods listed: Chronic Oversupply (1997-1998) with Oil Price Peak 12/31/2006; 2000 -2002 Recession with Oil Price Peak 8/31/2000; Great Financial Crisis (2008-2009) with Oil Price Peak 6/30/2008; OPEC Price War (3Q2014-1Q2015) with Oil Price Peak 6/30/2014 ; U.S. / China Trade Conflict (Fall 2018) with Oil Price Peak 6/30/2018.