Correlation between oil prices and stock markets – Fact or Fiction?
It is a commonly held view that rising oil prices directly and negatively impact the economy and the stock market. This is because it is generally felt that an increase in oil prices will raise input costs for most businesses and force consumers to spend more money on gasoline, thereby reducing the corporate earnings of other ventures. The opposite should be true when oil prices fall. However, does oil really drive stock prices or is the correlation weaker than it is made out to be? In this blog, the likely divergence of oil prices and stock markets will be further explored.
Oil and Cost of doing business
A drop in fuel prices is presumed to directly lead to lower transportation costs which should leave more disposable income in people’s wallets. Also, since many industrial chemicals are refined from oil, lower oil prices benefit the manufacturing sector including lower costs for mining plant and equipment. However, if a country increases its oil production (e.g., the United States), low oil prices can potentially hurt oil companies and affect domestic oil industry workers. High oil prices add to the cost of doing business and these costs are ultimately passed on to the consumers.
Reasons for Oil not driving Stock Prices
It has been theorized that other price factors in the economy—such as wages, interest rates, industrial metals, plastic and computer technology—can offset changes in energy costs. This can lead to a diminished impact of oil price shocks and hence, capital markets remain insulated to an extent. Another possibility is that corporations have become increasingly sophisticated at reading futures markets and are better able to anticipate shifts in factor prices; a firm should be able to switch production processes to compensate for added fuel costs. Some economists suggest that general stock prices often rise on the expectation of an increase in the quantity of money, which occurs independently of oil prices.
It has also been observed that the oil market is much more positive about the economy, both in the U.S. and globally, than are stock traders. History shows that when that kind of dichotomy exists, oil traders are right more often than not, in part due to that enforced short-term outlook in oil. Stocks are being driven lower by fear of what might happen and oil is being pushed higher by what actually is happening.
Distinction based on Definition
Oil prices are determined by the supply and demand for petroleum-based products. During an economic expansion, prices might rise as a result of increased consumption; they might also fall as a result of increased production. For instance, front end oil futures contracts look no further than a month out. Because of that, crude is being less influenced than stocks by what the Fed may or may not do later this year and, right now, the economy is strong.
On the other hand, stock prices rise and fall based on future corporate earnings reports, intrinsic values, investor risk tolerances and a large number of other factors. Even though stock prices are commonly aggregated and lumped together, it is possible that oil prices affect certain sectors much more dramatically than they affect others.
The Final Word
It stands to reason that oil prices impact stock prices in some sectors, e.g., transportation is strongly correlated with oil prices as the dominant input cost for transportation firms is fuel. However, for other sectors, oil is not likely to have a dominant impact partly because the stock markets function differently compared to the oil market. In light of the Russian invasion of Ukraine, the oil market is more volatile than however – however this may be a golden opportunity to invest in some stocks which are trading low now and which have great potential (irrespective of whether they are dependent on oil prices or not!).