Oil price plunge: How the market reacted and what it means for Fed rate cuts

September has once again proven challenging for investors, with the spotlight on the oil market. This week, global crude oil prices dropped to a three-year low, hovering below $70 per barrel, driven by cooling demand. Brent crude futures, the global benchmark, also fell by more than 3.5%, while West Texas Intermediate (WTI), the U.S. oil benchmark, dipped to $65.75 per barrel.

Why are oil prices falling?

Several factors are contributing to the current decline in oil prices. One of the main reasons is a slowdown in global demand, particularly in key economies. OPEC’s latest monthly report revised its global oil demand forecast for 2024, dropping it from 2.11 million barrels per day to 2.03 million barrels per day. The weaker demand outlook, especially from major consumers like China, has significantly affected the market. China's economic slowdown, coupled with a potential U.S. recession, is reducing demand for crude oil, further pressuring prices.

Oil products demand in China is forecast to decrease by 1.1% annually between 2023 and 2025, with the drop accelerating in subsequent years, a China oil researcher told Reuters. Declining Chinese oil demand from the growing adoption of liquefied natural gas (LNG) trucks and electric vehicles (EV), as well as China's slowing economic growth following the COVID-19 pandemic, has been a drag on global oil consumption and prices.

China's oil products demand shrank 0.5% on year in the first half of this year, mainly led by a 5.8% drop in diesel. The consumption is set to decline 1.3% in 2024.

However, US Energy Information Administration expect ongoing withdrawals from global oil inventories will push prices back above $80/bbl this month.

Standard Chartered has predicted a $3.02/bbl increase in dated Brent for the week ending September 16. Standard Chartered noted that whereas it’s going to take time for oil markets to start paying attention to actual fundamentals, positioning has turned extreme enough to skew price risks to the upside.

The US has maintained its position as the top crude oil producer globally for six consecutive years, increasing supply. This has contributed to the oversupply issue, making it difficult for OPEC+ to balance the market through production cuts. Despite ongoing efforts by Saudi Arabia and other OPEC+ members to curb production, the surge in U.S. output and weaker demand have exacerbated the price decline.

Market reactions and forecasts

The bearish trend has led to a significant reduction in bullish bets on oil prices. Data from exchanges cited by Bloomberg shows that bets on rising oil prices for both Brent and WTI crude were slashed by 99,889 contracts, marking the lowest level of bullish positions since 2011.

While the decline in oil prices can be seen as beneficial for major importers like India and Pakistan, it also poses risks for Oil Marketing Companies (OMCs). Indian oil and gas companies, which have experienced stock drops, are feeling the pressure. Shares of ONGC, Oil India Ltd., and IOC have all witnessed declines in recent weeks, despite expectations that falling crude prices could boost their profit margins.

ICICI Securities notes that while the decline in oil prices could improve profit margins for Indian OMCs, there are concerns about a potential drop in earnings for upstream companies if prices continue to soften. However, brokerage firm Prabhudas Lilladher remains optimistic, predicting that oil prices will rebound to the $75–80 per barrel range in the near term due to delayed OPEC+ production increases.

Impact on Federal Reserve's monetary policy

The recent drop in oil prices has important implications for the Federal Reserve's monetary policy, particularly as it grapples with the dual mandate of managing inflation and supporting economic growth. Lower oil prices will push US Federal Reserve to slash rates by 25-50 bps in the next meeting.

Investors are anticipating the Federal Open Market Committee (FOMC) will cut interest rates for the first time since 2020 at the upcoming meeting this month.

Historically, oil has been a key driver of inflation, especially in sectors like energy and transportation. As oil prices fall, so do the costs associated with these sectors, which has a cooling effect on overall inflation. According to Christoph Rühl, Chief Analyst at Columbia University’s Center on Global Energy Policy, “Lower oil prices would be extremely beneficial, particularly for central banks, as it would alleviate inflationary pressures—precisely what monetary policymakers need right now”.

With oil prices hitting multi-year lows, futures markets have started to reflect growing expectations of potential interest rate cuts. Bloomberg reported that traders have begun pricing in as much as 250 basis points of rate cuts by the end of 2024 if deflationary forces continue to build. This expectation stems from the belief that lower oil prices will not only help temper inflation but also signal a slowdown in global economic activity, potentially prompting the Fed to act .

In line with this, U.S. bond yields have fallen, and the yield curve has steepened—a typical market reaction to expectations of lower inflation and a more dovish Federal Reserve. “The drop in oil prices has contributed to a growing sentiment that the Federal Reserve may need to pause or even cut interest rates to prevent a sharp economic slowdown,” said Tim Drayson, Head of Economics at Legal & General Investment Management .

However, while declining oil prices may help tame inflation, they also point to broader concerns about global demand. A slowdown in China’s economy, combined with potential weakening in U.S. economic activity, suggests that the decline in oil prices could be a symptom of softer global growth. The International Energy Agency (IEA) noted that weakening demand, particularly from major consumers like China, is driving much of the pressure on oil prices, which in turn is creating deflationary risks .

Despite these risks, the Federal Reserve is likely to remain cautious. As James Knightley, Chief International Economist at ING, pointed out, “If we achieve a soft landing, the return to 2 percent inflation will be gradual. But if we experience something more severe, the risk of a sharp downturn will be substantial” . This underscores the Fed's challenge: balancing the need to control inflation while avoiding an economic downturn.