Stocks' Swoon Finally Hits Oil

The ongoing turmoil for Chinese and U.S. equities may signal the start of a dip in global oil demand

The past week's disconnect between crude oil prices and the decline of stocks may be starting to unravel as oil traders grapple with a fundamental issue: How sound is China's economy?

A 9% sell-off in Chinese markets Feb. 27 sparked a weeklong slide for stocks in Asia, Europe and the U.S., and the selling continued Mar. 5 (see, 3/5/07, "Stocks End Lower in Seesaw Session"). For much of last week, however, oil prices were oblivious to equities—and actually rose in the days after the initial stock jolt, nudged higher by lower U.S. fuel reserves and the prospect of sanctions against Iran (see, 3/12/07, "What the Market Is Telling Us").

But for now, the new math on oil is resting firmly on whether China's stock market correction reflects underlying weakness in one of the world's fastest expanding economies—and any sign that China's strong thirst for oil could be waning.

Unpredictable Market

"China is the barometer by which we gauge global economic growth," says Fadel Gheit, senior energy analyst for Oppenheimer & Co. in New York. After a year when the Chinese stock market surged 130%, the Chinese government is cracking down on what it considers a black market of nonregistered companies. But it's unclear whether that problem is the tip of a bigger iceberg. "Getting accurate information on what's really going on in China's market is the holy grail right now," says Steve Schork, principal of the Schork Group, which publishes an energy industry newsletter.

The uncertainty led to a 2.6% drop Mar. 5 for futures of the benchmark West Texas Intermediate crude. The April contract settled at $60.07 a barrel on the New York Mercantile Exchange after falling as low as $59.60 in earlier trading. "The sell-off definitely spooked speculators out of the market," says Gheit. "When the market slid down they went running for the hills and safer ground."

In recent years, the growth of China's economy has become a critical support to oil prices because of demand there, and in India. Last year, crude oil consumption in China increased 7.1% from a year earlier, helped in large part by growth in private car ownership. In 2007, domestic demand for both crude and oil products is expected to increase about 6%, according to Chinese state media reports last month.

A Temporary Dip?

As a major engine of growth, Chinese demand directly affects oil prices. "A 1% drop in demand translates into about a 10% drop in oil prices," says Craig Pirrong, professor of finance and energy markets at the Bauer College of Business at the University of Houston. "So a few points off on Chinese economic growth easily means a couple-percentage-points drop in demand for oil." Pirrong predicts oil prices falling into the low $50s or even the $40s in coming months, though Gheit and Schork see a range of $55 to $65 per barrel.

As with any fluctuation in the price of oil, the key question is whether the change is a temporary move, or the sign of a trend likely to continue. At a minimum, some analysts see the turmoil provoking a deflation of the speculative air that has surrounded oil prices. "The energy bulls have spun their case and hyped growing demand and a strong global economy as the reasons to buy in this market," Schork said. "But if you take one leg out from under this market it will continue to fall."

The Chinese government itself has long sought to cool the nation's sizzling economic growth, fearing overheated investment and social disruptions. On Mar. 5, Chinese Premier Wen Jiabao said in his annual policy speech to the National People's Congress in Beijing that the country will curb investment and lending to prevent the economy from overheating. Wen cut growth targets from 11% to 8%.

China's Power

Not every trader is persuaded by such policy goals from across the Pacific. "I'm still a big believer in China and its growth," says Ray Carbone, a trader with Paramount Options, a small commodities trading firm in New York. "The government can say things and cause a knee-jerk reaction [in markets], but there's a lot of money in China and huge consumer demand. You couldn't stop it if you wanted to."

To be sure, problems in the U.S. economy—quadruple the size of China's—could spell just as much of a concern for slowing economic growth. Amid a crisis in the subprime housing market and lower-than-expected durable goods orders, worries of an American slowdown are causing jitters on Wall Street. Former Federal Reserve Chairman Alan Greenspan said last week he wouldn't rule out a U.S. recession this year.

Still, oil prices are near their highest levels in two months and far above the 20-month lows they reached in mid-January. "Markets are about perception, and China is on everyone's mind," says Schork. "Whether [oil] prices are weakened or supported depends on how the Chinese economy shakes out."

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