Oil’s Slippery Slope And What Happens Now

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Oil’s Slippery Slope And What Happens Now

On Tuesday November 13th oil prices checked the “bear market” box (almost as if they were being pursued by actual bears), dropping by more than 20% over just the prior 20 days. The drop between October 16th and yesterday actually amounts to a 22% decline ($71.93/barrel for WTI then, $56.22 now).

But you know how we think: that number may look big, but how does it stack up against historical trading patterns?

We pulled daily front-month contract data for West Texas Intermediate back to 1986 and looked at trailing 20-day price changes (about the length of a calendar month). Here’s what we found:

  • On average, US crude oil prices rise by 0.72% every 20 trading days.
  • There is, as one would expect, a lot of volatility around the mean. The standard deviation of that 20-day price change is 9.85%.
  • In other words, a rise or fall of 9 – 10% for oil prices in a given calendar month is entirely normal since they fit into one standard deviation of price volatility.
  • The 20-day move through yesterday, with a 22% decline, is solidly outside the norm. Using normal distribution math, this should only occur 2.5% of the time.
  • Worth noting: oil price changes fit a normal distribution very well indeed. Since 1986, there are 206 days when 20-day trailing returns have been worse than 19.0% (+0.72% minus 2 times 9.85%). There have been 8,553 days since January 1st 1986, so 2.5% of that number (the left tail of the normal curve) would predict 214 days of sub 19% returns. Close enough to actual results, that…

Therefore, a 22% decline is statistically unusual so what happens over the next 20 trading days? We pulled the data back to the start of 2000 to get a sense of the modern history after such events:

  • There have been 14 distinct prior instances where WTI dropped more than 20% (i.e. similar to the drop through yesterday).
  • The average price change over the next 20 trading days was +1.9%, showing that crude prices do not quickly bounce back after an outsized decline.
  • Historically, the worst-case scenarios were 4 instances in 2008 (Financial Crisis) and once in 2014 (the last bear market for crude). Average 20-day price changes after a 20% drop averaged a further 17% decline.
  • The best cases after a 20% decline for WTI were in 2003 (going into Gulf War II), 2010 (at the start of China’s post-Crisis stimulus) and 2015 (end of the last oil bear market). These averaged a 31% increase for crude after a +20% drop.

The bottom line to all this in 2 points:

#1. The post-2000 history for crude prices tells us not to expect a bounce over the next month. While prices here are volatile, that 1.9% average short-term gain after a quick downdraft indicates crude prices tend to settle out rather than pop after a 2-sigma drop.

#2. While the 2018 peak for WTI in early October matches the top of the S&P 500, and both have dropped seemingly in sync since, history shows correlation isn’t always causally linked by worries over the end of an economic/market cycle. This was certainly the case in 2008, but not in 2003, 2010, or 2014 for example.

Key takeaway: look for oil to settle out here as a sign the recent decline is just a reset of supply expectations. If it breaks lower by another 20%, that will be a good sign more serious global macro issues are afoot.