Explaining The Big Drop In Oil Prices

As I'm sure you are aware, over the last week and a half, U.S. stocks have taken a massive hit. The reason we are told, is that the widely followed and frequently indicative forex and Treasury markets are both suggesting that inflation fears are growing. It is understandable if all the potential ramifications of that elude you as inflation was last a real problem back when Reagan was President, but most know that it involves higher prices of goods and commodities. So, logically speaking, inflation fears should be pushing oil higher, right? Wrong.

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As you can see from the above chart for WTI futures (CL), the U.S. benchmark crude contract has instead dropped around ten percent from the highs, following the stock market lower. If you think about it, though, that shouldn't be a surprise. Stocks, like commodities should also logically trade higher on inflation expectations, but they are collapsing too, so something else must be going on. In fact, it is not one thing, but several things that make this seemingly counterintuitive move perfectly understandable.

First and foremost, what the stock market is reacting to is not the prospect of inflation per se; it is the prospect of the response to the prospect of inflation. Part of the reason that inflation has not really been an issue in the U.S. since the days of big hair and disco is that the Federal Reserve Bank has become a lot better at seeing the warning signs of rising prices and taking preemptive action when they appear. The first part of that action is to increase interest rates, and it is the prospect of that that has markets spooked.

Following a recession of historic proportions, America, indeed the world, has been in a long, drawn out period of recovery, with low but consistent growth encouraged by ultra-low rates. As the U.S. steadies at what looks like full employment, though, and prices start to edge up, we should be coming to the point where the policies that have facilitated that steady growth are gradually reversed. The problem however, as is so often the case, comes from politicians.

The passing of a budget that offers massive spending increases to go alongside the tax bill that blew a huge hole in government revenue makes sense only as a cynical, foolish attempt to grab votes. In case you think that I am making a partisan point here, I am not. The Democrats pushing for even more spending after bleating about deficits as the tax bill passed are as culpable as the Republicans who spent eight years bleating about the same thing as the deficit fell on an annual basis under Obama, and who are now blowing up the Federal budget.

One of the many negative effects of such stupidity is that it forces the Fed into an unenviable position. They know that we have reached a critical point in the recovery and that the economy is still fragile, but they also know that the bond market now has a genuine fear of ballooning debt and are looking to them to raise rates rapidly in response. That would choke off the future growth that has been priced into both stocks and commodities, hence the big drops.

From a stock market perspective, it is important to remember here that this is about fear, not fundamentals. In that case, both earnings and economic conditions indicate that the economy could well be strong enough to withstand rate hikes, so this looks like a needed correction that provides an opportunity to buy at a discount. WTI, however, is different.

What this move has done in this case is to change the narrative. Traders have been focused on the prospects for stronger growth and have bid oil up as a result, but now that that growth is being called into question have shifted to concentrate on the ever-increasing U.S. crude supply.

I have been concerned about the same thing for a while, and not just because of the domestic effects. The agreement between OPEC and other interested nations to cut supply has, so far, been adhered to. That, however, flies in the face of the history of such agreements, so it is not a big leap to suggest that if the signatories see continued evidence that what they are doing is enriching U.S. producers, it will fall apart.

Oil's drop in the face of possible inflationary pressure may not seem to make sense at first glance, but dig a little deeper and it not only makes sense, but also looks likely to continue.