November 29, 2018,   9:48 AM

Global Market Uncertainties Behind The Sudden Drop In Oil

Jameel Ahmad

Jameel Ahmad is the Global Head of Currency Strategy and Market Research at FXTM. He specialises in financial market developments, with a particular emphasis on global currencies, commodities and emerging markets. FULL BIO

oil processing equipment and machinery

November has not been a kind month to the oil markets. The commodity has transitioned from hitting a near four-year high early in October to seeing its value drop by close to $20 in six weeks. Oil has during this time have flirted with bear market territory beforeas recently in Mid-November, suffering its biggest one-day decline since 2015 at 7%.

What has exactly caused such a sell-off?

There are two different questions to ask at this point. The first is what exactly caused the selling, with the second aspect being whether this negative momentum will continue further. The most mentioned answer to the first question is that this was caused by the United States unexpectedly providing temporary waivers for eight nations to continue importing oil from Iran, but this is not what has encouraged the oil markets to decline so drastically.

Oil  was already in a period of deep selling before this news came through, and what it might have helped encourage is some further selling pressure.

Numerous external uncertainties in the global market are to blame

What has not been discussed enough when looking at the correlation behind the recent volatility in oil is the likelihood that numerous external challenges to the global economy are catching up with demand for the resource. This will be elaborated further on below, however another aspect that is linked to the same theme is the repeated warnings that have been aired over the second half of 2018 over the global economy being at risk to a downturn.

This has more recently been reinforced by weakening GDP readings from economies across the globe.  China, Germany and Japan have all announced declining GDP readings since the beginning of the fourth quarter, with the latter two announcing economic contractions over the past week alone. The narrative has been similar across emerging markets and not just major developed nations like Germany and Japan. South Africa recently downgraded its growth assessment for 2018 by close to half its projection just six months ago, while Malaysian authorities have also revised down their own growth assessment for the Malaysian economy.

The unpredictable global environment is the prime reason why the outlook for the global economy has become bleaker. Trade tensions between two of the largest economies in the world, prolonged strength in the USD and the relentless pressure that this is putting on emerging markets, coupled with the unpredictable nature of the Trump Administration, and other issues like Brexit and the Italian budget represent just a few of the several reoccurring challenges to global economic growth.

It is these fears over market uncertainties and what impact this can have on global GDP that is behind the selling in oil.

Why concerns over global economic health impact oil

Oil is a commodity whose value fluctuates in accordance with supply and demand dynamics. When there are concerns over the health of the global economy, is it only natural that questions will be raised over whether this can impact demand for oil. When you then consider the supply of oil available remains on the high side, it brings home why the oil price can become sensitive.

The commodity is also considered as a “riskier” asset to hold in an investment portfolio, therefore when there is uncertainty in the market it is not unusual to see the price of oil decline.

Low Oil prices can support pressured emerging markets

One other aspect to consider is that there are positives to weaker oil prices in the current global environment.

While I agree with the headline view that higher oil prices are more beneficial for the GCC economy in the long-term - it does need to be considered that prices beyond current levels are very challenging for emerging markets to afford. Net-importers of commodities, like Indonesia and India have seen their currencies weaken beyond 10% in 2018. The Indonesian Rupiah has declined to its weakest level in over 20 years, while the Indian Rupee remains within distance to historic lows against the USD.

At time of writing the USD has actually advanced against all of its emerging market peers across the world tracked via the Bloomberg terminal.

There are a great deal of net-commodity importers throughout emerging markets, therefore there is a very valid point to make that lower oil prices are more appropriate given the current market environment.

Can oil prices bounce back?

Of course, and despite the headline that oil has found itself back in a bear market appears worrying, it does need to be pointed out that the current value of the commodity is around double the 13-year lows last seen in early 2016.

Given the current unpredictable market and the risk external uncertainties are bringing to the global economy, the current valuation for oil is actually reasonable. When you factor in that respected institutions are warning that the global economy is at risk to “plateauing”, it adds a risk of slowing demand for commodities like oil. If there is reduced demand for commodities then it will naturally weigh on the value of oil.

Overall and when you weigh up all the factors that are making the global economy very challenging as we begin to unwind 2018 and look ahead to next year, I maintain my view that lower oil prices would be more appropriate for the global economy until these external uncertainties are removed and restore a level of contained investor confidence.

Is there a catalyst that could help oil prices recover?

Keep a close eye on the as of now scheduled meeting between President Trump and senior Chinese authorities at the G-20 meeting in Argentina late November. There are faint hopes that the United States and China could agree on a new trade deal at this time, which would remove one of the greatest external uncertainties (trade tensions) from the financial market. This would also provide the needed confidence to investors and some optimism back into the global economy.

And it might also encourage investors to pull the trigger on pricing in higher oil prices as a result of improved economic optimism.  

Jameel Ahmad is Global Head of Currency Strategy & Market Research at FXTM.

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