How Oil Affects the Stock Market

The basic rule is: oil up, stocks down, and vice versa. This isn't hoary old trading lore, either, but verified by modern studies that we'll discuss below.

Oil Prices and Supplies

The crude oil market is the largest commodity market in the world. Total world consumption in 2013 was about 91 million barrels a day, of which the United States consumes approximately 20% (22% for natural gas); yep, it is the single largest oil products consumer on the globe. That's right: we burn one out of five barrels produced, even though we have less than 5% of the world's population.  But a few years ago it was 25%, or one out of four barrels. The US is the third-largest oil producer, after Saudi Arabia and Russia.

But, though growing, US oil demand has been offset by its production increases. Demand in Central/South America, Asia, Central Asia, the former Soviet Union and many other countries is growing generally by double digits, a result primarily of increasing mechanization generally and many more cars on the road, specifically.

Several times total consumption is traded daily on crude oil, spot, futures and over-the-counter markets at exchanges in New York (NYMEX) and London (IPE).

But gas prices have been down lately, way down. What gives?

When global oil production increased by 3.85 million bpd (barrels/day) over a 5 year period, US oil production increased by 3.22 million bpd, which is almost 85% of the global increase. This increase is of course due to the fracking-caused oil shale boom. This means that US oil imports declined and its finished-product exports (e.g., gasoline, diesel, jet fuel) increased. During the same period China’s production edged up very slightly though its demand keeps spiraling; the result: China’s dependence on oil imports keeps growing and production—don’t.

Oil prices for US consumers should have dropped some time ago in light of our production increases, but oil oligarchies tend to manipulate supply to keep prices artificially high. Predicted oil prices of $150-200 per barrel have not materialized, mostly due to US shale oil production, but they got high enough—about $145. In 2013, the average price of Brent crude was $108/bbl, down about $3 from 1012. Prices for West Texas Intermediate (WTI) crude, though, averaged about $98/bbl, which as an increase of nearly $4/bbl over 2012.

As this is written (Dec. 2014), oil prices have crashed close to 20% in the past month, as OPEC aggressively attempts to drive the US shale-oil (fracking) industry into the ground. Their logic for pumping more oil is to bring prices down to the point that it is no longer economical for US users to buy shale oil, which is somewhere south of $80/bbl.

Robert Rapier of EnergyTrendsInsider.com predicted back in January 2014 that oil prices would fall significantly and wrote recently that, “I am surprised it took this long for [oil] prices to fall.”

The price and production data used above comes from British Petroleum’s Statistical Review of World Energy 2014 report, which see.

The following chart, courtesy of Infomine.com, shows the history of oil prices going back to to May 2000, with prices at $72.22/bbl (Brent; WTI price was $69.38) when this chart was pulled:

If oil goes to $60/bbl or so as some are predicting, shale oil production may become a thing of the past. But once shale oil production disappears and the rigs and fracking equipment have been sold for scrap, the oil-thug countries OPEC will raise prices again.

There is strong price support at $80, which is being tested now. I expect that test to take months or a year or more to resolve. There also is strong support at $60, but whither it stops, nobody knows.

Economic Effects of Oil Prices

Oil is used for so many things, I couldn't even list them all in this article. From petroleum we primarily make gasoline and diesel fuels, heating oil, fuel oil that is burned to generate electricity for a large part of Earth's population, greases and lubricants, and of course, plastics of all kinds. And this list is just the tip of the iceberg, although they account for the majority of petroleum used. Now of all these uses, ask yourself which ones are seeing a decline in demand or production. The answer is NONE.

Demand is increasing for everything I can think of that we make from petroleum. Naturally, increases in petroleum prices have an effect on the economy, and thus indirectly on consumers, but—increases also affect consumers directly. World demand is not increasing in relation to production as fast as the darkest predictions had it, but the annual demand increase is inexorable.

When prices go up, prices at the pump soon follow, sometimes almost immediately. Let's say you are an oil refiner and you have stocks of $30/barrel oil on hand. Then oil starts moving up and the price increases to $40. You don't sharply raise prices instantly, because the oil you buy to replace stocks as they are used up will cost you more. So you increase the wholesale prices to distributors, which quickly translates to higher prices at the pump. You buy oil futures to hedge against price increases, of course. Petroleum industry players are always buying and selling crude oil futures. Most traders buy and sell oil contracts like any other security.

As your cost of crude goes up, you keep raising wholesale prices of the petroleum products you make, and each increase raises prices at the pump. Gas prices are high because oil prices are high. There’s a lot more to gasoline prices than that, obviously, such as price manipulation, Mid-East wars, fears of Mid-East wars and so on. But my point is that pump prices will never, can never, be low when oil prices are high.

I’ve noticed something else in the course of my misspent life: when oil prices are rising, pump prices go up a lot faster than pump prices come down when crude is falling.

Higher prices at the pump hurt individuals (and SUV sales) directly, since more money out of the budget for gasoline means less money to spend on burgers, at WalMart and so on. But the indirect effect on consumers is also pronounced. Businesses pay higher prices for gas products, also. Prices in stores increase as it costs more to ship the goods. It is a spiral, and everyone in the chain of production and the chain of retail sales increases prices. Shippers and airlines typically pass energy-price increases on to consumers in the form of fuel surcharges.

When oil prices rise and, worse, remain high for a long period, energy-dependent businesses inevitably will suffer. Transportation (trucking, airlines, overnight couriers, etc.) is the most vulnerable, and auto companies can expect a drop in sales of gas guzzling models. Money spent by consumers on oil is money not spent on other goods and services, obviously. That squeezes profits and sales on a host of businesses.

I want to point out a very interesting paper entitled Striking Oil: Another Puzzle, issued in November of 2003 by the Rotterdam School of Economics. The authors point out that, prior to the 1970s, oil prices remained stable throughout most of the twentieth century, due to a combination of production and price controls by the “Seven Sisters,” which were the largest oil companies in the world.

This price control came unglued by the Yom Kippur War in 1973, when control of world petroleum production and prices shifted to OPEC. At that point, oil prices began behaving like the prices of other commodities. The following graph of petroleum prices says it all. Shown are WTI crude prices from 1947 to 2003, in US dollars per barrel.

Source: Global Financial Data Inc.

Look at that chart move around after 1973! It's like what happened after the preacher's kid was let loose in Sinville. But remember, oil is not just any commodity. It is THE commodity. Well, if it had not been the Yom Kippur war it would have been something else. The old price-fixing ways were a lot better than the new price-fixing ways, in my book.

Higher oil prices essentially act as a tax, slowing economic growth. So rising oil prices should kill the stock market, right?

Oil and the Stock Markets

Many believe the old saw that the stock markets move inversely to oil; that is:

Oil up, stocks down;
Oil down, stocks up.

And that’s true, but only sometimes. The following chart, courtesy of Greg McKenna, BusinessInsider.com, is an eye opener. The black line represents the WTI crude price and the maroon line the S&P 500, which will serve as our proxies for oil prices and stock markets. Oil shot up while the S&P crashed in 2007 for most of the year and part of 2008. But from March 2009 (when the market conclusively turned back up) on, the stock market and oil moved together.

Until late 2013, that is. Note how oil and stocks diverged at that point, then moved together again soon after and in the summer of 2014, diverged again—big time. Greg McKenna suggests that the stock market should be afraid; very afraid.

In the 2007-08 price divergence, oil went up while stocks crashed. But in the latest divergence, the market is sailing while oil is crashing. Logically, doesn’t it make sense that with oil finally falling, there will be dancing in the streets (and there is) and economies everywhere will benefit from a lessening of the ever-present “tax” of high oil prices? When we take the handcuffs off the economy, why wouldn’t the market soar?

But look at the above chart more closely: while rising oil might drive stocks down as in 2007/8, it affords us no evidence that falling oil causes stocks to rise.

The stock market has risen steadily with only minor corrections since Autumn of 2011. It is very possible McKenna is correct and that a real stock market correction is coming. He did not predict this squarely, suggesting only that the above chart is scary for the stock market. But that clearly is what he meant.

In light of this chart, keep a close eye on stock-market behaviors and indications of exhaustion at this potential top, such as advances on lessened volume.

On the other hand, it is possible that the market is not exhausted and that oil will turn back up instead of stocks correcting.

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