In just one week, oil prices skidded by more than 10%, sparking a selloff in U.S. equities of 3.5%, a Treasury rally of more than 20 basis points, and global headlines of growth fears and tumult. Surprisingly, I'm not talking about last week. The week I'm referring to was in early December, and it is rather similar to the present oil price action and market response.
During the week of Dec. 8, oil fell 12.2%, to about $58 a barrel; the yield on 10-year Treasuries approached 2%, from about 2.30%; and equities declined over 3.5%. At that time, I
published a commentary establishing a downside target for oil at $50 a barrel and said that the yield on the U.S. 10-year note would slip to about 1.9%. Many of those predictions seemed pretty extreme at the time, but here we stand. At the time of this writing, oil is hovering around $48 per barrel and the yield on 10-year Treasuries is 1.96%.
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Technically speaking, after breaking through the support level of $50 a barrel, the measured move for oil is now $34 (based on the minimum downside potential price, according to the rules used by market technicians). I believe we are in for a prolonged period during which oil trades in the $40 to $50 range, and possibly lower. In fact, I have the investment teams running stress tests based on oil's trading at $25 a barrel for an extended period.
Twenty-five dollars a barrel? Isn't that a bit extreme? I would guess, but so were our stress tests in 2008, which assumed short-term rates could go to zero for a prolonged period. The current bear market for oil is the result of a supply shock brought on by fracking. Based on the unwillingness of global oil producers to reduce production, the current supply shock will take awhile to work its way through the system, and oil prices have yet to find a bottom. Better to evaluate the downside scenarios now than to be unprepared.
The difference between this bear market in black gold and the bear market of 2008 or the 1998 experience, which was associated with the Asian crisis, is that both of those were demand shocks. The best historical comparison to what we're witnessing today in oil prices is actually the supply-shocked world of the mid-1980s.
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The 1985-86 bear market in oil was the result of oversupply — too much oil was brought online relative to demand. Prices declined more than 67% over four months or so. Prices started to rise again in April 1986, and credit spreads tightened a few months later. Within 12 months, the stock market was up over 20%. If history is any guide — and in this instance, I believe it may be — we are likely to see a similar situation play out.
But beware in the near term. Even at $48 a barrel, oil is still a falling knife — I believe there remains another significant downside move. If we hit the price target of $34 a barrel, which I believe we could, that would be another 30% decline in oil prices. Typically, people would rightly characterize a 30% decline as a bear market. We've already had a decline of over 55% from the high, so we've been in a bear market, but if we started over today, we're going to have another one.
The development of fracking has driven a huge increase in the oil supply. By most estimates, fracking ceases to be profitable when oil prices hit somewhere in the neighborhood of $40 a barrel. Once the frackers stop drilling new wells, the following 24 months should see oil output gradually decline. That will allow prices to stabilize and ultimately rise to something viewed as normal, above $60. Until supply begins to contract, oil will languish. Between now and then, anything energy output-related should continue to suffer from weak oil prices.
WILL THE OIL PLUNGE MIRROR THE MID-80S' SUPPLY SHOCK?
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Over the past 30 years, there have been six major declines in the price of oil (defined as a greater than 50% cumulative decline). The current decline stands at about 55%, matching the magnitude of some of the worst historical oil crashes. But most of the past declines have been due to faltering global demand, whereas the current slump is due to a supply glut.
Therefore, the best comparable decline is that of 1985-86, when a supply shock caused the price of West Texas Intermediate to plunge more than 67% over the course of four and a half months. With no near-term signs of oversupply, oil prices could continue to fall.
Scott Minerd is chairman of investments and global chief investment officer of Guggenheim Investments.
