Falling oil production is a red flag for the global economy. | Image: shutterstock.com
- The number of active U.S. rigs fell to an 80 year low in May.
- But a storage capacity shortage will keep a ceiling on oil prices.
- And slashed production is a woeful signal for GDP and the stock market.
The stock market rally seems unstoppable as the world economy begins to reopen. But the latest readout on a critical leading indicator of future oil production shows the rally may be premature. If the economy contracts as far as production indicates, stocks may be doomed to another correction.
U.S. oil production has crashed to an all-time low according to data released by energy services firm Baker Hughes Co. The company has counted active U.S. rigs weekly since 1940. The count provides an early leading indicator of future output.
The rig count fell by 34 to a record low of just 374 actively operating oil rigs. During the first week in May last year, that figure was 988, so this week’s count represents a 62% year over year collapse in active rigs.
But don’t expect falling production to boost prices for long. There’s still a massive supply glut and hardly any capacity to store the new crude output.
Storage Shortage Will Keep A Ceiling on Oil Prices
Oil Price for A Barrel of Brent Crude, The International Benchmark (YTD) | Chart: TradingView
As hopes for reopening the economy buoy the stock market, the rising price of oil the first week in May has also given equities a boost. But analysts are warning equities markets not to get too excited about oil prices
Nicholas Cawley, market economist at Dailyfx.com wrote in a Wednesday note:
Front-month WTI oil futures will continue to be volatile until the storage problem is resolved and traders are confident that if their position expires they will be able to store oil at a reasonable price.
He added that excess supply will remain unused for the foreseeable future:
With global economic activity unlikely to pick-up in the foreseeable future, demand for oil will remain low and the current imbalance against excessive supply will continue to cap any rally in WTI oil futures.
Last month, West Texas Intermediary, the U.S. benchmark for the price of a barrel, cratered into negative territory for the first time. A week later, Mizuho Bank analyst Paul Sankey warned oil could crash to negative $100 per barrel in May.
Oil Production Reveals Frothy Stock Market Rally
1YR Graph showing the correlation between the stock market (S&P500 Index in Red) and oil prices (Brent Crude in Blue) | Chart: TradingView
The stock market correlated closely with oil prices in the months leading up to the COVID-19 panic. Equities seemed to be taking their cue from crude markets.
In the last six months of 2019, both markets moved in tandem, with stocks slightly lagging oil. Strategists watched the crude market to gauge the recession risk to future economic growth.
Julian Emanuel, head of equities and derivatives strategy at BTIG said in January:
Stocks were far less of a lead indicator and more of a concurrent indicator than they usually are. Oil really got caught in the same geopolitical uncertainty downdraft. The price of oil is telling you there isn’t going to be a recession. It’s firming up. To me that’s the feed through loop into equities.
Falling production, along with historic low prices, is a distress signal for the global economy. The stock market continued to rally during the 2014 oil price crash because GDP was growing. The barrel crashed as the U.S., Canada, and Saudi Arabia ramped up production.
But today, there’s a massive supply glut as the oil industry scales back production to historic lows. Meanwhile, GDP is in a severe contraction.
This will have a direct impact on equities market benchmarks through energy sector stocks as a debt-laden energy industry faces a sustained demand shock. Meanwhile, it’s an overall leading indicator of an economy in depression.
So don’t look at oil prices and expect that stock market rally to last.
Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com. The above should not be considered investment advice from CCN.com. The author holds no investment position in oil or U.S. equities at the time of writing.
This article was edited by Aaron Weaver.