Why Oil Prices Are Likely To Climb From Here

One of the things that has always appealed to me about the energy sector from a trading and investing perspective is that it usually isn't correlated with the US stock market. I have natural exposure there with my retirement and other investments, as I'm sure most of you do too, and having an interest in something that moves independent of equities not only smooths out the bumps along the way but also reduces the temptation to make bad mistakes, like selling at or near the bottom of a drop when the pressure mounts. If I am making money elsewhere, it is much easier to just ride out periods of weakness in my long term investments and actually keep to my regular buying schedule, which logic suggests, and every study ever done has shown, is the right thing to do.

There are times, though, when the two things seem to be directly interacting, when the price of oil, and therefore of most stocks in the energy sector, seem to have either a direct or inverse relationship with the broad US market. Over the last year or so, that has been the case. There has been an inverse relationship, with higher oil prices prompted by a global shortage of supply raising inflation worries in America, and therefore prompting selling of US stocks. The Hamas attack on Israel and their response raised even more concerns about oil supply initially, but recently, as immediate regional contagion fears have faded, the supply concerns have faded, and crude has dropped based on a weak global growth outlook.

What is interesting, though, is that as that shift has taken place in oil over the last week or so, the inverse correlation between US stocks and crude has increased. But now, oil is not driving stocks. Inflation in the US is moderating, and crude in the $80-90 range, while higher than historical average prices, is not high enough to drive price increases throughout the economy. The best explanation for the fact that the two are moving in opposite directions, then, is that there is absolutely no connection or correlation. That is what the chart below, which compares the performance of SPY, which tracks the S&P 500, and USO, the US Oil Fund, suggests.

Figure 1: 1-Month Chart comparing SPY and USO

Stocks are bouncing back a bit as American data show less inflationary pressure from wages and elsewhere, with Treasury yields falling back from their highs. Meanwhile, oil has fallen as concerns about global growth are outweighing the effects of tight supply. It doesn't take a genius to understand that those two things aren't really compatible. If the US is looking at a "soft landing", with the Fed in complete control and avoiding a crash, then what are the chances of there being a global recession soon? Sure, China has its own problems, the Middle East is being the Middle East, and Europe isn't exactly capable of carrying the world with the Russian war in Ukraine still raging but, even so, if the US avoids a major slowdown, the end of the year will see an increase in oil demand that will bring supply back into focus.

So, the logical conclusion is that, for a while at least, crude has some catching up to do and should move higher. That contradicts the long-term view that I had just a couple of weeks ago based on an analysis of the factors influencing the supply of and demand for oil, but sticking to your guns when there is new evidence to be found is not admirable consistency, it is stubborn stupidity. That is true in life in general, but doubly so in trading and investing, where the analysis of data is, or should be, the only thing that drives decisions.