Oil Prices Tumble: Noise or Fundamentals?

Brent futures prices tumbled more than 6 percent on Monday, a highly unusual move that has raised questions about whether shifting fundamentals will send the market even lower over the coming months.

Over the last month, front-month prices have dropped 17 percent, breaking out of the very narrow range that had prevailed since the middle of April.

Reasons for the drop are not hard to find. The Financial Times on Tuesday set out the six bearish factors that have come together to produce a perfect storm for the oil market ("Oil re-enters bear market", July 7).

These include China's stock market tumble, turmoil in Greece, prospects for a nuclear deal with Iran, rising oil output from OPEC, an uptick in rigs drilling for oil in the United States for the first time in over six months, and bearishness among commodity-focused hedge funds and banks.

But the significance of the big move on Monday and the wider decline in oil prices over the last month is much harder to assess because large daily moves in the price of oil and other commodities do not correlate well with new information about supply and demand.

Of the six factors identified by the Financial Times, we can discount three (Greece, Iran and OPEC) as explanations for the big move this week and over the last month because they have long been known and should already have been incorporated into prices.

That leaves China, the uptick in U.S. rigs and increased bearishness among hedge funds and commodity banks as new information to explain the sudden plunge in prices.

None of them offers a particularly convincing explanation for such a large price shift in such a short time (http://link.reuters.com/geg25w).


             
China Shares
China's equity market has lost almost a third of its value since the middle of last month and so far resisted all attempts by the authorities to stabilise share prices.

There are fears the slump will worsen the country's economic slowdown and translate into slower growth in demand for a broad range of commodities from crude and coal to iron ore and copper.

There is certainly some risk to the economy of the world's largest oil importer, but the link between the stock market and commodity consumption remains tenuous.

"Political risks associated with the current fall (in share prices) are far greater than the economic risks," said Michal Meidan of consultancy China Matters in a research note published on Wednesday.

"There is a clear disconnect between economic fundamentals and the stock market: this disconnect was just as palpable when the market was making dramatic gains as it is in the current bearish sentiment."

Meidan argues the "stock market crash will have limited impact on the domestic economy and oil-demand growth".


         
U.S. Rigs Rise
The other genuinely new information in recent days was the jump in rigs drilling for oil in the United States last week.

The number of rigs increased by 12, the first gain since Dec. 5 after 29 consecutive weeks in which the oil rig count declined (http://link.reuters.com/qag25w).

It has been clear for some time that the downturn in drilling was bottoming out, but the increase in active rigs was a surprise.

It comes after some shale firms had begun to talk about the prospect of ramping up their drilling programmes and production in the second half of 2015 and in 2016 if prices continued to rise.

For bearish commentators, the climb served as confirmation that oil prices have risen too far, too fast and are not consistent with the need for a further slowdown or even fall in shale production.

"Not only did $60 per barrel oil, strong high yield and equity energy markets create an increase in U.S. drilling last week but the market structure of the New Oil Order has generated incentives for low-cost producers such as core OPEC and Russia to ramp up current and future production," Goldman Sachs wrote in a research note.

"We reiterate our fundamentally driven forecast for lower oil prices," Goldman concluded ("The 3D's of macro push commodity markets lower", July 8).

But there are reasons to be cautious. The increase in rigs was very small - just 12, or 0.2 percent, after the rig count had fallen by 981 or 61 percent over the previous eight months.

Rigs counts show considerable variability (the standard deviation of the weekly change is 13 rigs) so the statistic is noisy and last week's increase was not in itself significant.

Moreover, the rise in rigs drilling for oil (+12) was almost matched by a drop in the number of rigs drilling for natural gas (-9). The decline in gas rigs was the largest in 13 weeks.

It is possible some rigs are being redirected from gas-rich to oil-rich formations or simply that drilling targets are being reclassified from gas to oil.

Some stabilisation or even increase in the number of rigs drilling for oil has long been anticipated: the decline could not continue indefinitely and the industry needs to replace declining production from existing wells.

But can such a marginal increase in the number of rigs drilling for oil explain a fall of 6 percent in oil prices on a single day or 17 percent over the last month?


             
Fear and Fundamentals
Whatever the explanation, the decline in the front-month Brent futures contract on Monday was unusually large.

In the quarter century since the start of 1990, prices have fallen by a greater percentage on only 54 days out of almost 6,500 (http://link.reuters.com/sag25w).

Large falls have sometimes coincided with fundamental news about supply and demand, such as when OPEC decided in November 2014 not to cut its production despite the slide in prices.

However, large falls have also occurred in the absence of significant news about supply or demand, as happened during the "flash crash" in May 2011.

The relationship between news flow and short-term price moves is comparatively weak and makes linking the two notoriously hard.

Sentiment and market positioning often exert a bigger influence on prices in the short term, even if fundamentals are decisive in the medium and long term.

Sentiment and fundamentals need not be mutually exclusive explanations. Sometimes a shift in sentiment can crystallise a long-building reaction to fundamentals.

"The fall in oil prices (this week) is a story of fear and fundamentals," historian Daniel Yergin wrote. "Fear is the trigger for seeing fundamentals of supply and demand more clearly."

But sometimes abrupt price shifts reveal nothing more than a crowded market, with too many participants trying to trade in the same direction at the same time.

(By John Kemp)