The Oil Collapse: White Swan Or Black Swan?

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Includes: DIA, IWM, QQQ, SPY, USO
by: Brendan O'Boyle

Summary

The price of oil and other commodities have collapsed over the past six months.

The last cycle of monetary policy tightening unleashed a black swan as the housing market collapsed.

Is the crash in oil yet another black swan? Or perhaps a white one.

I along with many others have been blindsided by the relentless decline in the price of oil. Since last July when WTI topped $105/barrel (NYSEARCA:USO), the decline has been unforgiving to anyone who tried to call a bottom. In fact, if anyone had told me six-months ago that oil would trade under $50/barrel I would have assumed a dire financial crisis or recession must be the culprit. I would never have believed it possible that the S&P 500 (NYSEARCA:SPY) could trade near its 52-week high, while the price of oil was more than cut in half. And yet here we are.

However, it is not only the price of oil that has fallen. The prices of nearly all commodities, such as iron ore, copper, silver, platinum, corn and cotton have fallen dramatically as well. The CRB index has overall declined by nearly 30%.

This is a very important concern for investors in stocks because the selling in commodities represents a very real deflationary headwind for the global economy. I was thinking about the recent decline in oil in the context of the current economic cycle. Then I thought back to previous economic cycles, particularly the housing crisis in 2008. It is intriguing that as soon as the Federal Reserve was within eyesight of closing its bond-buying program the price of oil fell into a spiral. Most markets look 3-6 months into the future and oil topped in June, roughly 5 months before asset prices were reduced to zero. While stopping new asset purchases may not appear to be tightening, I would argue that it constitutes de facto tightening. In this sense we have finally reached the stage in this economic cycle where fiscal conditions are being tightened.

Figure 1: WTI Crude, the S&P 500 and the Federal Reserve's Balance Sheet

The argument can be made that there is a 'supply glut' in the price of oil. A number of articles have been put forward on this site that are fairly skeptical of this view. While the ratio of demand/supply has declined to a low as of late, the decline in the price of oil seems to be an extreme overreaction to the downside. Interestingly, similar levels in the ratio of oil supply and demand led to much more manageable declines in the price of oil while the Fed was still easing.

Figure 2: Oil Demand/Supply Ratio Vs. Brent Crude Oil Annual Percentage Change

Source: Ed Yardeni's Blog.

It is worth remembering what happened during the last economic cycle when financial conditions were tightened. Beginning in mid-2004 the Fed raised the overnight rate from 1% to 5% by mid-2006. Though it took a good deal of time eventually this cycle of higher rates popped a bubble that had formed in the price of housing. We all remember what came next, a black swan of immense ferocity.

Figure 3: The Previous Economic Cycle - Housing Prices, the S&P 500 and the Fed Funds Rate

So the question remains: has the latest round of ultra-low interest rates created another speculative bubble, this time spurring investment toward the production of oil? And now that de facto tightening has arrived could we be on the cusp of another black swan?

Or is there a chance that the decline in oil is actually a white swan. In other words, could the decline in the price of oil, even if it arose out of monetary excess, be a tonic for the global economy? Indeed, there are many cogent arguments to be made that the declining price of oil actually returns money into the pockets of consumers. Based on the most recent GDP report the economy is growing at a healthy clip.

Figure 4: Real GDP Growth and Retail Sales Consistent with Continued Economic Growth

So put all the plusses and minuses into a balance sheet and decide. Is the oil collapse a white swan or a black swan? At this time there is no question more important to the future direction of the market.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.