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Low Oil Prices Could Point To A More Serious Problem

Low Oil Prices Could Point To A More Serious Problem

West Texas Intermediate sold for $105 a barrel at the start of July, but ended last week at $58. The most important factor has been surging U.S. production. But another reason oil prices have slid so much is weakness in demand for the product, which may be related to a slowdown of overall world economic growth. Here I comment on the importance of that second factor.

Price Of Crude

Price of crude oil (West Texas Intermediate, dollars per barrel). Source: FRED.

For example, the price of copper fell from $3.27/pound to $2.93, a 10% drop over those same six months. This of course has nothing to do with the success of people in getting more oil out of rocks in Texas. Softness in demand for commodities like copper and oil may be one indicator of new weakness in the world economy.

Price Of Copper

Price of copper (NYMEX, dollars per pound). Source: Investing.com.

The yield on 10-year U.S. Treasury bonds is also down almost 50 basis points over the period, for which I believe the most plausible interpretation is again weakness in the world economy.

Related: Ten Reasons Why A Sustained Drop In Oil Prices Could Be Catastrophic

Treasury Bond 10 Year Interest Rate

Nominal interest rate on 10-year Treasury bonds. Source: FRED.

And the dollar is up 11%, which I attribute to the same cause.

U.S. Dollar Index

Trade-weighted index of the U.S. dollar. Source: FRED.

Related: US Shale Under Pressure From More Than Just Low Prices

To get an impression of the quantitative importance of these developments, I regressed the weekly change in the natural logarithm of the crude oil price (here’s why I use logarithms for this) on the change in the 10-year yield and the change in the logs of the copper price and the value of the dollar using data from April 2007 to June 2014. Here are the results of that regression, with t-statistics in parentheses as calculated using a Newey-West adjustment with 5 lags:


I then used the coefficients from that historical relation to see how much of the drop in oil prices since this summer we would have expected to observe, given the observed drop in copper prices and the 10-year yield and the rise in the value of the dollar. Those predicted values are plotted as the dashed line in the figure below, with the actual price of oil in solid black. Even if we knew nothing on the production side of the oil market, we would have anticipated the price of oil to have fallen from $105/barrel in June to $85 dollars today on the basis of these other three potential indicators of world economic activity.

Actual WTI Price vs Value Prediction

Actual price of West Texas Intermediate (in black) and value predicted on the basis of the above regression (dashed blue).

In other words, of the observed 45% decline in the price of oil, 19 percentage points– more than 2/5– might be reflecting new indications of weakness in the global economy.

By James Hamilton

Source - http://econbrowser.com/ 

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  • Seasoned_Citizen on December 16 2014 said:
    Roger that, Jmaes!

    Like the old Limbo Bar song goes: "...how LOW can you GO?"
    (I'm really showing my age, n'est pas?)

    Here's another dimension--FACTS which we normally rely upon from countries, industries, and corporations to form our projections, are increasingly proven to be false and/or fraudulent.


    Until vast swathes of consumers wake up to feel it's an economic "brand new day" and start to spend and invest, things look bad.
  • Bro East on December 16 2014 said:
    Just as those who came out of the great depression.... after years of austerity (tight budgeting), people will remain reluctant to spent.
  • mj on December 16 2014 said:
    OIL price drop is a US and Saudi manipulation in an effort to kill 3 birds with one stone. Iran, Russia, and ISIS (greater Syria)

    Iran is under the threat of sanctions and if they leave the nuke deal greater risk with poor oil revenues.

    Russia is totally dependent on energy exports and with them in the Ukraine and their support of Assad It is in Saudi and US interest to squeeze Putin's Economy into oblivion.

    ISIS is also dependent upon oil exports and they were undercutting oil markets with black market oil it makes sense from a Saudi perspective if ISIS does not implode from this. King Abdulla knows ISIS is in their back yard as early as next year.

    Cheap oil is not hear to stay but it will be with us for the near foreseeable future. Until Putin's Economy folds, ISIS indigenous populace implodes, Assad is gone, Iran comes to the table with real Change. The only tight rope we walk though is if we become so unwound and WWIII breaks out. After all the players are invested deep.

    Putin is looking forward to his quasi dictatorship and revival of the USSR

    China cannot afford a soft economy

    Europe cannot have a rogue Russia in their back yard.

    And the revived Ottoman empire is in the air. Just a little more blood and the extremist will have the largest most powerful empire the world has ever known.

    And of coarse the US foundations are making groaning noises a USA vacuum would spell WW3 as the world nations would clamber for juxtaposition for world domination.
  • Kevin on December 16 2014 said:
    No bear here. Because the data presented seems to be mined and processed in an existing manner, I don't put as much value in it.
    Reason: What the new generations are proving to use as commodities or better yet, where and what they are placing value on now is different then the previous generations.
    Technology alone is even causing a shift in industrial material demand.
    This is rarely considered.

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