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.