The Relationship Between Oil and Credit Markets

What happens to the bond market when the oil futures move?

Crude oil has hit almost a 5-year low, dropping down to $42.74 a barrel. The movement comes from output increases from resource-rich countries of Nigeria and Libya, who are unrestricted in how much they can supply.

There are signs of rising production all over the world, with futures moving into bear territory due to the simple law of supply and demand. The more oil there is, the lower the price is.

It’s like candy. If you had 1 piece of candy, and 100 customers, you could sell that piece of candy to the highest price the bidders chose. However, if you had 100 pieces of candy and 1 customer, you would have to bring your chosen price down to match that to the expectations of your customer.

Supply and demand.

With oil, it seems as though OPEC is doing a bad job at distributing its candy effectively. We have a lot of pieces of candy (lots of oil) and because of that, the price of candy has to drop.

There is also the problem of locking in prices for future delivery, as American drillers often do. Basically, they are given a guaranteed price for the oil that they pump. If the market tanks, they still have their chosen price locked in, so they really don’t care (too much) if we have a glut of oil.

When we have a glut of oil, the credit spread seems to hit new highs. This is a “measure of how much the credit-worthy banks pay to borrow”. Corporate bonds are divided into investment grade bonds and high-yield securities, and both sets of these bonds are more expensive.

This is because that oil producers are in debt and there is an increased risk in the marketplace. When oil prices decline, there is a higher likelihood that the producers will not get as much as profit as they were expecting from the production cycle. When they don’t get enough profit, the producers are unable to repay loans they took out. When they are unable to repay their loans, the overall market becomes riskier.

Because when the big guys can’t pay back, who can?

Thus, in a series of causations, we see the credit spread increase when crude oil decreases. This is one of the nuances of the market – how intricately woven everything is, and how everything is codependent.

It reminds me of that little story of the butterfly flapping its wings in Mexico that causes a hurricane to happen in China. Our whole world is that delicate, that close to the brink of prosperity and destruction.

So if a butterfly can wreak all that havoc, how much havoc can an oil cartel focused solely on profit, without any mind for the worldwide economies wreak?

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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