19 October 2018

The Macroeconomics of Oil - Do Not Wish Down Oil Prices

Are we in an Economic Winter? Can Oil tell us anything about where we are in the market cycle? I think it tells you a lot. Just as Copper is called Dr.Copper Oil maybe the HOD - or head of the department. 

Jokes apart in today's note I want to highlight and trash the popular opinion that a falling price of Oil is not exactly good for stocks medium to long term. While it maybe good for the Macroeconomic picture while considering Oil losses and the Current account deficit, Oil prices are part of the commodities basket and the commodities cycle with some lead lag reflects the strength of the economy. It is unfortunate if you think otherwise but it maybe only because the business media and the analysts concerned come online saying it is so. That lower Oil prices would be bullish factor. These are based on short term term thinking and sometimes such short term relationships may exist but longer term they do not. As the following charts will show this thinking can be the most misleading advise at the wrong time. So are analysts to blame for their short term thinking? Maybe not as that is what they are often expected to do.

So let us get into the big picture and let me start with this Model that I have discussed  before from Martin Pring. There is a reason why stocks bonds and equities peak and bottom with some lead lag effect around each other. More often than not stocks lead and then commodities follow. Stocks are the first indication of a possible change in trend for demand supply factors based on social mood and behaviour. Commodities prices reflect that when actual factors change along with a change in speculative positioning. The cycle repeats over and over.

The last time I used this chart was in 2015 when we also saw stocks and equities decline worldwide but as the following charts show it was not only 2015.

Let me start way back in 1998, that goes back 20 years. Now few will remember 1998 from an Oil market perspective. At the time Oil prices fell below 10$ for the first time. The chart of OIl futures here shows 10.32 as the low but the ET at the time reported 9-8$. It was headline news that Oil had fallen to or below the cost of production and this was the lowest price in decades. My thought was immediately that maybe this is the biggest buying opportunity in OIl just because it has fallen to a senseless level. No charts, had taken a sabbatical to study at the time. But here is what you should also know about 1998, India ran an ''Oil Pool'' account below the balance sheet to pay for Oil purchases, meaning that the government was taking losses from Oil imports on its own books and not passing it onto consumers or to Oil companies fully. This was not added to the annual budget and a seperate account or contingent liability of sorts. The Oil Pool loss had once gone above 10,000 crores and was considered a burden at the time. In the last week of 1998 as Oil hit 10$ India'a Oil Pool loss was totally wiped out and for the first time we thought of doing away with the Oil pool account. At the time the Nifty was at 800 down from its 1997 high of 1297, down 38%. As this chart shows both rose together and then fell together, except for a short period between the top of the tech bubble in Feb 2000 and Sept 2000. On both occasions oil and stocks peaked together except that Oil was higher in Sept. So would you say that higher Oil prices popped the tech bubble? And when oil prices fell again why didn't the market go up?

The truth is that these short periods as above are often used to highlight or blame one for the other, but mostly both go together. When falling Oil prices improve the Macros it is usually the bottom of the market as well because Oil prices fall due to falling demand and recession. The positive rub off on Macros then is a symptom and not the cause.

Now apply the same here 2001-2009, both Oil and stocks bottomed 2 months apart in 2001 and then went up for the next 6 years together. In 2008 there is a 6 month lag between the top in both assets after which both went up together. During that phase in the midst of a bear market, in June 2008, our FM raised rates blaming Oil for some inflation. As if that helped bring down Oil prices. But that 6 month window is where everyone gets to talk about high oil bad for market and low oil will be good. But when Oil prices crash with stocks what do you hear? Rarely does anyone tell you that rising Oil prices would be good. In 2003 I sent a note to the research head highlighting that Oil would go to 35$, I was told well then the country would shut down. So deep is the thinking about Oil and its impact on the economy. But rising Oil was only reflecting expanding demand and money conditions that are generally bullish. So did Oil collapse the housing bubble or did the Housing bubble collapse Oil?

And the story goes on to 2014. This time is different. After 2011 commodities prices started to fall off a cliff slowly and Oil as often seen in all the examples above is the last one to give up. And so it did in 2014 finally. Good for stocks? It might seem so. For a window of 9 months it was. After that Oil had fallen so far that Emerging markets like Russia were crying for a drop of water, and maybe that is why they were encroaching on their neighbours. But for Nifty after 2015 both Oil and stocks fell together. More important is to note that both Oil and Nifty bottomed in Feb 2016 and went up together. So if there was any reason to think that stocks would go up after 2016 maybe it was Oil right? What also happened in this time or so is reported is that the long elevated period of 100$ Oil led to the explosion of the US Oil Shale industry, because suddenly it was possible to produce oil from old dried out fields by a new technology and at an attractive price. This led to overinvestment in Oil in the US.

Fast forward to 2016-2018. Rising Oil and rising stocks. So was Oil from 26-70 bad for stocks? Can't see why and where. In fact now that the US is in the Oil game the fall to 26 made it very clear that US shale producers are crowding out the US junk bond market for debt that they cannot pay if Oil prices fall down too far. Any surprise that they have been on a war footing with OPEC, Korea, Libya and more recently Iran. Keeping global supplies in check has been key. However this week for the third time prices are finding it hard to hold above 70. If Oil prices have peaked are they good news for stocks? Stocks have been giving the lead signal for a while that we are done going up. Commodities prices have not made new highs for months too. Crude Oil was then the last man standing as in all the examples above. Oil is the last. Once Oil breaks 70 or 66 and is not above to hold then it would be the last nail in the coffin for the global economy as it is Dr.Oil and HOD. Falling Oil is good for Indian Macros, year sure so was it in 2015 but that did not keep the stock market from losing 25-30%. Why should this time be different?

Remember there are short periods of time lasting weeks or months at important turning points that Oil and Stocks appear to be inversely correlated and it makes nice to talk about in the news and explain the market movements but this causal relationship has no long term historical precedence as shown in the charts of the last 20 years. It is for this reason that Robert Prechter coined the phrase ''All The Same Markets'' explaining that liquidity at the center is driving all the related markets up and down together.

The Truth About The Markets - Rohit Srivastava