Oil shock

Lower oil prices typically boost global growth, but the recent decline to an 18-year low will likely provide less support than usual. We estimate weak demand was responsible for more than half of drop since the beginning of the year. This is a symptom of sluggish activity, not a cause of future expansion.

• We split the oil price movement into demand and supply drivers. We estimate about 54% of the drop is due to weak demand as the spread of the coronavirus weighs on global growth.
• Ample supply accounts for the remaining 46%. Producers, such as Saudi Arabia and Russia, have started a war over market share following the collapse of the OPEC+ talks.

Oil is facing a toxic mix of negative shocks to both demand and supply:

• The slowdown in global growth is hitting demand. Activity data in China, an early center for the virus, were dire in the first two months of the year. The spread of the virus to other parts of the world, the enforcement of lockdown measures in a number of countries and the collapse in air travel have had a huge impact on oil demand.
• The International Energy Agency expects appetite for oil to fall by about 90,000 barrels per day in 2020 compared with last year — the first decline in demand since 2009, the peak of the global financial crisis.
• The supply picture is also negative. Not only did the OPEC+ group of countries fail to accommodate the drop in demand by cutting output, they’ve entered into a price war to gain market share.
• Saudi Arabia is planning to raise output by at least 2.3 million b/d in April. The United Arab Emirates intends to increase production by more than 1 million b/d. Russia could add a further 200,000 b/d. These are huge quantities in ordinary times. They’re massive in the current exceptional circumstances.

Global Economy

A drop in oil prices shifts income from producers like Saudi Arabia and Russia to importers like the euro area and Japan. For the global economy the net effect from this shift is typically positive — consumers spend a higher portion of their energy-bill savings than producers cut outlays.

But the impact depends on the cause of the oil price decline. A demand-driven drop is a reflection of weak activity — it’ll reverse once the economy recovers and won’t provide a permanent boost to growth. But an increase in supply could be longer-lasting and a catalyst for future expansion.

Weak demand accounts for the majority of the oil price fall since the beginning of the year, so the boost to global growth would probably be smaller than the $40-decline suggests. As far as the impact on global growth is concerned, it’s as if crude prices have fallen from $66 per barrel at the beginning of the year to a current level just below $50 — instead of the actual $26 price seen now.

Even the $18 supply-led drop is coming at the same time as the coronavirus threatens to trigger a full-fledged global panic. Its immediate impact could still be negative. Oil producers would take an immediate hit. Oil consumers won’t spend more if they’re under quarantine. The reality of the brutal drop in prices adds to the sense of panicked uncertainty.

How We Measure Oil Demand, Supply Shocks

Oil prices decline because of either weak demand or higher supply. These two factors affect equities differently, meaning we can use stock price changes as an instrument to separate oil demand shocks from supply. Weak demand due to a slower global economy would lower both oil and equity prices. But a supply boost would reduce oil prices while lifting equities — lower energy costs make corporates more profitable.

If both oil and equities move in the same direction (higher or lower), that would indicate a demand shock. But if they move in opposite directions, that would signal a supply shock.

Impact of Demand, Supply Shocks on Asset Prices

To separate oil price changes into demand and supply, we do the following:

• We split the trading day into 15-minute intervals and look at the co-movement between oil and non-energy equities within each of these windows. (For oil we use Brent crude, for equities we construct a non-energy MSCI World Index)
• In each 15-minute window, if oil and equities move in the same direction, we attribute the oil price move to demand. If they move in opposite directions, we attribute the oil price change to supply. The assumption here is that in any 15-minute period, oil prices are affected by demand or supply, but not both.
• We treat non-trading hours (about three hours a day) as one long interval and attribute the oil price move then to either demand or supply, depending on the co-movement with equities.