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How does oil volatility affect the stock market?

An oil refinery at sunset.

The volatility of crude oil prices continues to disturb the world stock exchange. In a year and a half the barrel of Brent has lost two thirds of its market value. But what, if any, relationship can traditionally be found between these two factors?

17 december 2015

This week in December 2015, the barrel of Brent crude oil (petroleum reference for European countries) fell to its lowest levels since 2008. The 36.20$ floor the price of petrol hit on Christmas Eve of that year set a historical limit that many oil producing countries remember anxiously. High volatility has hit this market for the second time since the financial crisis began.

Tradition calls for drops in the price of oil to be welcomed by the stock market. The two values have been historically attributed a certain negative correlation: when crude oil is cheap, businesses, by and large, react favourably, and if on the other hand prices increase, most companies will adjust their expected profits according to cost increases, and thus their value. But since the financial crisis exploded the opposite phenomenon has happened: there has been a fairly constant parallelism between oil price and the stock market’s movements. Even going back a few years more.

Gráfico Correlación S&P500 y Crudo 07-12

Relationship between the S&P500 index and the price of WTI crude between 2007 and 2012 (via Business Insider).

 

Here are some facts and numbers that shed some light on the current situation:

  • A fall in the price of oil doesn’t affect all OPEC countries the same. In the midst of this petroleum cartel there are two separate factions: on one side, countries with large crude oil reserves, for which a price drop isn’t as harmful as a hypothetical loss of their market share; on the other, states whose economy depends excessively on petroleum sales. With this critical crossroads in mind, finding middle ground for all eleven participating nations is excruciatingly hard.
  • There is a general overproduction. The same OPEC nations have exceeded their self-imposed limit of 30 million barrels a day by 5%. And Iran is prepared to re-enter the market in a massive way.
  • Some net importers (USA) have reduced their dependence on foreign crude. In actual fact, the United States now produce more than they buy, thanks to, among many reasons, fracking. Also, the slowing down of the Chinese economy has pushed them to diversify their personal reliance on OPEC nations, looking instead to Russia or Brazil, among others.

Comparación Producción e Importación Petróleo EE.UU. 94-14

For the first time in twenty years, the United States produce more oil than they import (via U.S. Energy Information Administration).

 

The truth is that empirical evidence shows a very weak cause-effect relationship between the two concepts, among many reasons, because of the complexity of understanding their movements. Some studies show a higher causal relation in examples where oil prices increased than when they fell (as a sign of higher demand and better trust from investors). Others deny the existent in our times of any kind of correlation. It is difficult to establish a precise relationship, for many reasons:

  • We use oil a lot more efficiently than decades ago, and as such the impact of price volatility is lower.
  • In market indexes different companies coexist, many of which have varying relationships with petroleum. And every index is different. As such, in the S&P500 the weighting of Exxon is huge (third most important), but it weighs alongside several airlines.
  • The crude oil market is a lot more volatile than the market for gasoline. And that affects price variations: even though crude oil costs a third now than what is did 18 months ago, its derivatives, what the average citizen actually buys, haven’t been too badly hurt because of the wildly different costs that are part of their elaboration. This volatility doesn’t, therefore, have too big an effect on purchasing power either way. As a side-note, if oil price is reduced, so does the amount of taxes each state recollects, although spending can increase.
  • The Dollar/Euro exchange rate favours the American currency more each day that passes, which in return counteracts any price reduction in oil for European users (in the past year and a half, the rate has dropped from 1.36 dollars to the euro to 1.09 today). Same can be applied for other currencies against the dollar: pounds, rupees or the yuan.

 

Variations in the price of crude oil have important repercussions on the economy, but as far as the stock market goes the effects are often contradictory or touch radically different actors over the board. Changes are usually more circumstantial than applicable to financial theory. Difficult to find correlations in such a diverse climate.

 

Related content:

Crude oil and Wall Street destroy the IBEX – El Confidencial

Assets that win and lose with the fall in the price of petrol – Cinco Días

“Cheaper petroleum is better for everybody” – El Economista

Cheap oil endangers the worldwide “fracking” revolution - Expansión

 

Tags Market , Oil , Stock
 
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