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Why The Stock Market Likes Cheap Oil

Why The Stock Market Likes Cheap Oil

To listen to the talking heads on TV over the last few months you would think that there is a direct positive correlation between oil prices and the stock market. “Stocks fall as oil price decline continues” and “Stocks follow oil lower” or even “Markets bounce back as oil halts decline” have been common refrains. The implication is that lower oil prices are bad for the stock market, but in reality that could not be further from the truth. Historically speaking, the correlation between oil and stocks is around 20%. In other words it is virtually non-existent. If anything, logic tells us that lower oil prices, and particularly this drop, should be a buy signal for equity investors.

For sure, there have been times when a sharp drop in oil has heralded a period of stagnation or declines in stocks. For example, in the twelve months following the 1985 oil collapse the S&P 500 lost around 1%. On the other hand, one year after the 1998 low in WTI the S&P 500 closed over 8% higher. The fact remains, though, that recently stocks have followed oil. The obvious question is “why?” Related: Why Oil Prices Must Go Up

In general, currencies and commodities are the most sensitive markets to prospects for global growth. For this reason when oil falls stock traders have been conditioned over time to sell first and ask questions later. If there is any chance that a slowdown is coming it is better to be safe than sorry. In recent years that tendency towards an immediate correlation has been exaggerated by the advent of algorithmic trading. Computers react to price moves without consideration for the reasons behind those moves.

When we look closely at those reasons, however, it becomes obvious that this time around the benefits of lower fuel costs will easily outweigh any fear. Undoubtedly there was some concern about slower growth in China and a deflationary environment in Europe that contributed to the dramatic fall in oil, but both of those fears have subsided somewhat. The principle reason that oil halved in price was because of massively increased supply.

Technological advances, not just in the well publicized fracking for shale oil but also in deepwater drilling, have opened up previously unavailable reserves of oil all over the world. According to the U.S. Energy Information Administration (EIA), global supply increased by twice as much as demand from 2013 to 2014. That continues a trend that has been in place for a few years and has seen the world shift from an energy shortfall to a surplus. Once storage facilities began to fill again a drop in price was inevitable, even as demand continued to increase. Related: Oil Price Crash – What Next?

Without excessive concerns about global growth, lower oil prices, and therefore lower fuel costs, are a huge benefit to corporations outside the energy industry. Lower fuel costs in manufacturing, transport, retail and almost every imaginable sector will increase margins and free up capital for investment. Lower gas prices will encourage people to drive more, improving the outlook for auto companies and hotel operators. More car sales will increase demand for steel, aluminum and parts. The list goes on.

Lower oil prices are not without disadvantages. They discourage investment in cleaner alternative energy sources, for example, but to sell stocks in general on a fall in oil prices caused by a supply shock is folly in the extreme. Now that the initial panic has passed, both logic and history suggest that the stock market will come to love lower oil, and new record highs in the major indices look to be on the cards.

By Martin Tillier for Oilprice.com

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  • John Scior on February 20 2015 said:
    Just a few points to make. Exxon Mobile ( XOM ) and Chevron ( CVX ) are two companies in theDow Jones Industrial Index ( DJIA ) and thus many funds are vested in these stocks as a bell weather for the overall US economy. A decline in Oil prices over a prolonged period may trigger these companies to write down the value of their assets which affect return on assets and also return on equity. These metrics are utilized by investors to determine the quality of their investments and thus decreasing oil prices will indirectly affect their stock price. Now, as far as the profits these companies make, it may or may not affect the actual performance of said companies, depending on how vertically integrated they are, their profits may ctually increase. It hinges on why the price of oil is going down. A recessionary economy means that people are put out of employment and there exists a decrease in demand for oil derived products. This would be a situation where an oil price decrease would be concern for investors and these investors might very well be advised to sell their oil or energy portfolio. The current situation is different in that the drop in oil prices is a result of oversupply of oil. This actually might be good for oil companies in that a lower oil price spurs people to drive more, and economies to xpand. It also means that alternative energy and transport options ( ie electric cars ) become less attractive as they might be when gasoline was approaching the $ 4.00 per gallon price range. As time goes by Oil companies I believe will produce even greater profits ( within a 1 to 2 year period ) and investors who are buying today will be richly rewarded. Much of this goes to what you stated in your article in regard to algorithmic trading that does not examine the fundamental reason behind a drop in stock prices. There is a "herd" mentality when the sum total of all these programs execute trading in the same time period. I believe an investor in oil stocks will have a smile on their face and a fat wallet when in the May/June time frame another meeting is held between Russia and Saudia Arabia and the rest of the worlds Oil Producing countries decide they've bled long enough and come to a production output range that takes into consideration the reentry of Iraqi and Libyan Oil. Just consider the current downswing in the stock prices as a " seasonal sale"
  • Michael Ess on January 26 2016 said:
    One year later, and you are both so terribly wrong Tillier and Scior, perhaps you could actually admit you have no clue as what you pontificate about. Poseurs.

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