How Oil Prices Affect the Stock Market

Researchers at the Federal Reserve Bank of Cleveland looked at movements in the price of oil and stock market prices and discovered, to the surprise of many, that there is little correlation between oil prices and the stock market.

Their study does not necessarily prove that the price of oil has a very limited impact on stock market prices; it does suggest, however, that analysts cannot really predict the way stocks react to changing oil prices.

Key Takeaways

• It is a commonly held belief that high oil prices directly and negatively impact the U.S. economy and the stock market.
• A recent study, however, suggests that oil prices and stock prices actually show little correlation over time.
• One sector that is greatly influenced by the price of oil is transportation, which relies on petroleum fuel as a major input.

Correlation ≠ Causation

It is popular to correlate changes in major factor prices, such as oil, and the performance of major stock market indexes. Conventional wisdom holds 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 businesses. The opposite should be true when oil prices fall.

Andrea Pescatori, an economist at the International Monetary Fund (IMF), attempted to test this theory in 2008. Pescatori measured changes in the S&P 500 as a proxy for stock prices and crude oil prices. He discovered his variables only occasionally moved in the same direction at the same time, but even then, the relationship was weak. His sample revealed that no correlation exists with a confidence level of 95%.

Oil prices do have an impact on the U.S. economy, but it goes two ways because of the diversity of industries. High oil prices can drive job creation and investment as it becomes economically viable for oil companies to exploit higher-cost shale oil deposits. However, high oil prices also hit businesses and consumers with higher transportation and manufacturing costs. Lower oil prices hurt the unconventional oil activity, but benefits manufacturing and other sectors where fuel costs are a primary concern.

Important

In the spring of 2020, oil prices collapsed amid the economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows.

Oil and the Cost of Doing Business

The standard story is that the price of oil influences the costs of other production and manufacturing across the United States. For example, there is presumed to be a direct relationship between a drop in fuel prices means lower transport costs and cheaper transportation which leaves more disposable income in people’s wallets. Also, since many industrial chemicals are refined from oil, lower oil prices benefit the manufacturing sector. (This belief, however, might start to change as more companies adopt a work-from-home policy and as green energy sources and electric vehicles become more ubiquitous in the US.)

Before the resurgence in U.S. oil production, drops in the price of oil were largely viewed as positive because they lowered the price of importing oil and reduced costs for the manufacturing and transport sectors. This reduction in costs could be passed on to the consumer. Greater discretionary income for consumer spending can further stimulate the economy. However, now that the United States has increased oil production, low oil prices can hurt U.S. oil companies and affect domestic oil industry workers.

Conversely, high oil prices add to the costs of doing business. And these costs are area also ultimately passed on to customers and businesses. Whether it is higher cab fares, more expensive airline tickets, the cost of apples shipped from California, or new furniture shipped from China, high oil prices can result in higher prices for seemingly unrelated products and services.

Why Oil Does Not Drive Stock Prices

So why can’t Fed economists find a stronger correlation between the stock market and oil prices? There are several likely explanations. The first and most obvious is that other price factors in the economy—such as wages, interest rates, industrial metals, plastic, and computer technology—can offset changes in energy costs.

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.

A distinction needs to be drawn between the primary drivers of oil prices and the drivers of corporate stock prices. 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.

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 very possible that oil prices affect certain sectors much more dramatically than they affect others.

In other words, the economy is too complex to expect one commodity to drive all business activity in a predictable way.

Oil Prices and Transportation

One sector of the stock market is strongly correlated with the spot price of oil: transportation. This makes sense because the dominant input cost for transportation firms is fuel. Investors might want to consider shorting the stocks of corporate transportation companies when oil prices are high. Conversely, it makes sense to buy when oil prices are low. Of course, it remains to be seen what the impact of electric vehicles on the overall ground transportation sector will be in the future.

Read the original article on Investopedia.