The other day I was filling my tank up with gas. I always put the small lever up so it pumps automatically for me. I personally do not enjoy watching the money climb up in front of me. There is just something about it that is just so…crippling. Anyway, this particular time the nozzle did not stop when it got to the top and gas began to overflow and pour out onto the cement. It was like that scene in the Dark Knight where the joker burns that massive pile of money and the drug lord speechless. Unfortunately, I am not the joker and I DO care about money. I ran over a quickly as I could but I believe about $5-10 dollars was wasted on the ground.
Have you noticed a slow climb in gas prices recently? Filling up the tank has cost more than ever lately because of a rise in the price of oil. Oil has moved over $55 a barrel last week, the first time reaching those levels since July 2015. Have you also been noticing the stock market hitting all-time recently as well? Is there a correlation between the two? In this article, I’m going to be explaining the relationship between oil prices and the stock market. I will also be exposing the myth that the two always rise and fall in tandem of one another.
Who controls the output of oil?
The price of a barrel of oil moves up and down based off of supply and demand just like any other commodity or stock. When there is more drilling and more production, it causes an increase in supply which drives oil prices down. When there is a product cut (less drilling) then there is a decrease in supply which drives oil prices up.
The Organization for Petroleum Exporting Countries (OPEC) is an intergovernmental organization of 13 nations that determines when to cut or increase production of oil depending on the current supply and demand. It is estimated that these countries accounted for about 42% of the global oil production and 73% of the world’s “proven” oil reserves.
Correlation to the Stock Market
There has been wild speculation on the relationship of oil prices to the stock market. Some people believe there is a direct correlation with oil prices and stocks while others believe there is none at all. I say, it just depends. Let’s take a look at some charts of the correlation of stocks and the price of oil.
A correlation of 1 means that stocks and oil prices move in a direct relationship with each other. When oil rises, stocks rise along with it. A correlation of less than 1 indicates an inverse relationship with the price of stocks. In other words, when oil prices go down, then stocks will go up.
Oil is one of the most important commodities on the planet. When companies spend more money on oil, there is more production, and more money is flowing throughout the economy. This is why when oil prices are rising we should also see a rise in stock prices as well. There is more spending going on and companies should profit more from the increased production.
When oil prices start to decrease, many people can view this as a sign of economic weakness. Businesses will be cutting back production and in turn, will be receiving less money in revenue.
While rise oil prices can be seen as good economic growth, at what point does it become harmful to the economy? If oil prices keep rising, then businesses will have more and more expenses for the production of the products (cost of goods sold increases). We also have to think of you and I as the consumer as well. Higher oil prices means higher gas prices for us. Remember those terrible days of $4 a gallon? When we spend more on gas we have less disposable income and companies across the country are hurt by this because we do not buy as much of their products and services.
While there are times where we see a closer relationship between oil prices and stock prices, there are many other factors that come into play that I believe affect that relationship. These factors include the interest rate environment, wages, industrial metals, plastic and computer technology, that can offset changes in energy costs. In January of 2016, the correlation between the price of Brent and the S&P 500 stock index was at levels not seen in the past 26 years. The correlation was 0.97, higher than any calendar month since 1990, Since then, that correlation has slid and we have seen a great rise in stock priced compared to the rise in oil. So while I do believe there is a connection, I also believe you have to look at other factors going on in the economy. Sometimes investors are looking to see what direction the economy is heading and look to oil prices as a good indication.
As always, remember, the trend is your friend! If you see a direct correlation between oil prices and stock prices then ride that trend till technical charts tell you otherwise!
Homework: Go to Bloomberg.com and look up the current price for a barrel of crude oil. Use ticker symbol WTI or USO to keep track of how oil is moving over time.