Five Reasons Oil Is Driving The Stock Market
At its basic level the price of oil is a product of supply and demand. Other factors such as political turmoil can influence it but the main factor is supply and demand. At times and especially now oil is viewed as a proxy for the global economy, which has a ripple effect on the stock market. Over the past month the changes in the price of oil have had a very large influence on the US and international stock markets. There are at least five reasons for this which I’ve outlined below.
1. Lower oil prices may signal the global economy is slowing
Commodities such as copper and oil can be signals that worldwide economic growth is accelerating or decelerating. Oil was $100 a barrel in August 2014 and went into free fall to $45 in January 2015. It bounced back to $60 between May and June and then went into a slide and has been trading between $30 and $35 for the past month.
While lower oil prices are positive for US consumers and other countries that are large oil importers such as China, Japan and most of Western Europe concerns about lower growth rates in China are negating the benefits. China had been the driver for increased oil demand over the past five years and with oil prices collapsing it appears that its economy may be slowing more than anticipated. This is also exacerbated by concerns that the economic data released by China is rosier than it actually is.
2. Oil export nations are tapping into their stock holdings
Every large oil exporting country budgeted their tax revenues from oil at much higher levels. Saudi Arabia had $635 billion in foreign exchange reserves as of November 2015 and withdrew almost $100 billion from global asset managers over the past year. Russia’s monetary reserves dropped by $40 billion and could be exhausted in 2016.
For the 11 OPEC countries it is estimated that their budget deficits increased from $17 to $278 billion in 2015. At the current oil price their deficits will be larger in 2016. Norway has one of the largest sovereign wealth funds at $805 billion and is tapping into it to fill its budget gap. While not all the assets that these companies are selling are equities a large percentage must be due to their liquidity. This creates pressure on stock prices.
3. Oil companies cutting spending
As oil prices went over $100 the oil sector boomed in the US and one state that very high correlation of 0.9 for the 50 day rolling average between the S&P 500 and the price of oil. Back in 2013 people with no experience were being paid $100,000 and unemployment was 1% compared to the national rate of 7.5%.
Certain parts of Texas have also been hit hard. I saw a news story about a small oil supply firm that has seen its business drop 90% with only safety related equipment being sold. Another has laid off over 150 of its 200 employees. Exxon also announced that it was cutting its capital expenditures in 2016 by 25% which is billions of dollars.
4. Bank loans to the oil sector
Investors are concerned that a large number of loans that allowed US oil companies to rapidly expand fracking operations over the past few years will default. These companies took on a lot of debt based on higher oil prices and are now hanging on by a thread. While the oil companies continue to pump as much as they can, as long as it covers the marginal cost of extracting it, they are trying to generate enough cash to service the debt and stay in business. This of course keeps prices lower.
The ripple effect for the banks is if they have too much of their loan portfolio lent out to these companies the banks will have to write off a large portion of the loans. Investors are taking more of a shoot first (sell bank stocks they believe are exposed) and ask questions later. Having the price of oil stay low only makes this item worse.
5. Algorithms are driving stock movements based on oil price changes
There is a lot of fast money that gravitates to whatever trading system works. For at least the past month there has been a very high correlation of 0.9 for the 50 day rolling average between the S&P 500 and the price of oil (1.0 being that two assets trade in lock step, 0 being there is no relationship and -1.0 being they move in opposite directions).
Copyright: Forbes
