Are there signs of recession in the air? At least the recent decline in oil prices may suggest so. The last time oil prices suffered from such falls was in early 2020 during the Covid crisis that escalated to a deep albeit short-lived recession. This time, the landscape is different; while the stock market is hitting new record highs, the oil market is cooling down. Usually, oil and stock markets go in the same direction, so how can we make sense of the current situation?
S&P500 to oil price (WTI) Ratio 2020-2024
Source: FRED
Oil prices dynamics
Part of the decline in oil prices stems from concerns over weaker economic activity, especially from China – the largest oil consumer in the world. According to the recent OPEC and EIA monthly reports, the decline in oil is expected to be temporary for different reasons. OPEC estimates the recent fall is due to hedge fund speculation and bearish market sentiment. In addition, OPEC, much like the EIA, also has an explanation that address supply-demand dynamics: The decision of OPEC+ to cut production will likely raise withdrawal from inventories that put upward pressure on oil prices. The EIA estimates oil prices (WTI) should bounce back to around $80 a barrel in the coming months.
However, the IEA has a more bearish view and expects a weakness in global demand, driven by China and more robust non-OPEC production, especially from the US, that could offset some of the OPEC output drop. While OPEC and the EIA also mention China as the main factor for the recent softness of the oil markets, they expect the other factors mentioned above to overpower the effects of weak oil demand.
Oil and stocks
These developments in the oil market suggest that while it has been driven by bearish sentiment and concerns over global demand, it has less to do with the direction of the US economy, at least for now. While oil and stock prices tend to have a robust correlation, this relationship has breaking points and could sometimes be unstable.
US Stocks and interest rates
The rally in the US stock markets is also partly driven by the decline in short-term interest rates by the Federal Reserve, most recently in the September meeting, in which the FOMC cut rates by 50 bp. Moreover, the FOMC is expected to cut rates further in the coming months – providing an additional backwind for stocks to rise. These developments suggest that while oil and stocks have a robust and positive relationship, they have been known to break, and this time could be one of those occasions. It’s not indicative that stock markets are likely to follow oil prices and tumble, but rather that they were reacting to different market dynamics. For stocks, it is more related to the decline in interest rates, whereas a weaker demand outlook drove oil’s decline.