The black stuff is taking a dive. Brent crude has slumped to levels not seen since before the latest sabre-rattling in the Persian Gulf, brushing aside geopolitical jitters as the market refocuses on the stubborn reality of abundant supply. It is a sharp reversal from the risk premium that had inflated prices by several dollars just weeks ago, when the world held its breath over a potential disruption to Strait of Hormuz traffic.
For those of us who track the flow of petrodollars, this is a textbook case of market efficiency at work. The immediate threat of a supply shock has receded, and the underlying fundamentals are reasserting themselves. Global inventories are bloated, American shale production is humming along, and demand growth is faltering as the economic engine splutters. The market is doing what it always does: it prices in fear and then prices it out when the fear fails to materialise.
The trigger for this latest leg lower was a combination of factors: a surprisingly large build in US crude stocks, a stronger dollar, and a dose of reality from OPEC+ that their production cuts are struggling to offset the surge in non-OPEC supply. The cartel’s attempts to prop up prices are looking increasingly like a Sisyphean task. Every barrel they withhold from the market is a barrel that someone else is all too happy to provide.
This is bad news for the fiscally profligate nations that rely on oil revenue to balance their books. A sustained period of low prices will expose the cracks in their budgets, forcing either deeper austerity or more borrowing. For the rest of us, lower oil prices are a net positive: they put money back in consumers' pockets and reduce input costs for businesses. But do not expect the central bankers to break out the champagne just yet. Deflationary forces are already wreaking havoc on their inflation targets.
From a portfolio perspective, the volatility in oil markets is a reminder that commodities are not a one-way bet. The herd mentality that drove prices higher on geopolitical headlines has now reversed, leaving latecomers holding the bag. The lesson is clear: when the price of oil moves on fear rather than fundamentals, it is usually time to sell.
The gilt market has taken note of the oil price decline, with UK long bond yields easing slightly on the back of lower inflation expectations. The Bank of England may find itself in a bind: if oil stays low, headline inflation will undershoot their target, giving them cover to cut rates. But with the fiscal outlook deteriorating and the threat of a no-deal Brexit still lurking, any decision to ease would be fraught with risk.
In short, the oil price rout is a blessing for the economy but a curse for the speculators who bet on a sustained geopolitical premium. The market is clearing, and it will continue to clear until the next crisis rears its head. That is the nature of the beast. Stay nimble, stay sceptical, and never underestimate the power of supply and demand.
