Market commentators worldwide like to attribute movements in the stock market to current economic events and metrics. A favorite of many is the price of oil. You have likely seen news headlines linking fluctuations in oil prices to movements in the stock market.
While these headlines connect that day or week's market movements to a change in oil prices, there is no clear-cut correlation between daily oil price fluctuations and the broader stock market. Though oil prices are not a fantastic sole indicator of how the stock market may move, they can explain fluctuations in specific industries.
Who Sets Oil Prices?
Several factors influence changes in oil prices. Before diving into them, it is essential to understand what "oil prices" refer to. When someone refers to oil prices, they are referring to the oil futures market, where oil prices are set. This market is where investors can enter binding contracts that give them the right to buy a barrel of crude oil at a preset price and date. Once that date arrives, both the buyer and the seller of the barrel are required to fulfill the contract at the specified price and quantity.
As with all markets in the economy, oil prices follow the basic principles of supply and demand. Since oil prices are traded on a futures market, when investors believe the supply of oil will outpace demand, contract prices fall. Likewise, when investors believe supply will lag future demand, prices rise. For example, in 2020, after investors realized that COVID-19 would lead to a global shutdown, oil prices slumped by over 50%.
But what do investors look at as influencers of the supply and demand for oil?
OPEC stands for the Organization of Petroleum Exporting Countries. This group of 13 nations is responsible for nearly 40% of oil production and holds around 80% of the world's oil reserves. OPEC+ includes 10 more countries involved in oil production, contributing an additional 10% in global oil production and reserves to the organization.
Because OPEC/OPEC+ controls such a large portion of the world's oil, investors often look for statements (or a lack of statements) on production and supply increases or cuts to determine whether oil prices will rise or fall in the future.
In 2014, OPEC refused to taper oil production when demand in China and Europe faded, causing a slump in oil prices.
In times of uncertainty, such as the Russian invasion of Ukraine, Russia has control over certain flows of oil and gas, putting that nation outside the traditional movement of the market.
Disruptions in Oil Producing Regions
All markets turn wary in times of uncertainty. Forms of instability, whether governmental or natural, can lead to fluctuations in the price of oil.
In June 2008, oil prices hit record highs due to geopolitical instability in Nigeria and between Israel and Iran. Investors speculated that this instability would lead to oil supply disruptions, leading to the oil price surge.
Other things such as natural disasters in oil-producing regions can also hinder supply chains, causing price spikes.
Do Oil Prices Affect the Stock Market?
Logic would tell you that the two should have a negative relationship. After all, oil is used for energy which is a required input cost for many corporations. Corporate use of oil includes fuel for transportation costs (i.e., an airline such as United Airlines or a firm that simply needs to transport a lot of inventory such as Amazon), gas for heating and even electricity. These higher costs would negatively impact a company's bottom line, likely translating to a drop in share price.
To the surprise of many, a study conducted by researchers at the Cleveland Federal Reserve Bank concluded that there is little to no day-to-day correlation between oil prices and the overall stock market. This makes sense as a booming economy could also explain higher oil prices due to higher fuel demand. All told, oil prices do impact the stock market, but whether that impact is positive or negative depends on additional external factors.
Can Oil Prices Impact Certain Industries?
While the broader stock market may not be directly affected by oil prices, specific industries with high exposure to oil prices can be affected by fluctuations in its price.
The transportation sector of the stock market is one of these industries. As oil prices rise, the cost of fuel also rises. Fuel costs constitute a significant portion of operating expenses for airline companies, specifically.
Let's use Delta Airlines as an example. In the 2nd quarter of 2021, Delta reported an operating margin of 11.5%, and fuel and related costs amounting to approximately 23% of operating expenses. Thus, a 5% increase in fuel costs would have resulted in a decline in operating margin to 10.4% and nearly a 10% cut to operating income for Delta.
Aside from airlines, the transportation sector also encompasses ground-based transportation, trucking, shipping and logistics companies such as FedEx and XPO Logistics who operate fleets of fuel-based vehicles.
The connection between the performance of oil companies, particularly upstream companies engaged in exploration and production, and oil prices should seem somewhat clear. Exploration and production companies' input costs are largely fixed through the operation of drilling sites, while revenue is variable with respect to the currently traded price of oil. As such, when oil prices decline, their bottom line sees a noticeable impact.
Downstream companies engaged in refining oil into its finished product are not as significantly affected due to the variable nature of their input costs and prices of fuel. These companies buy oil from midstream companies that store and market it and sell it at a premium once it has been processed into a consumer-ready product.
Industrial companies with ties to the oil industry also see their stock prices move with investment by oil companies in activity and operational expansion. When the oil industry halts investment or even contracts operations, steel producers and oil services companies lose significant revenue streams and thus see their share prices plummet.
Do Oil Prices Affect the Market via Average Americans?
Fluctuations in oil prices affect average Americans most prominently through the price of gas. Rising fuel prices can be viewed as inflationary, thus impacting the stock market through average Americans in two ways.
First, the extra amount spent on fuel negatively impacts discretionary consumer spending. As a result, companies in the consumer discretionary sector may begin to see revenues decline slightly as people spend more on gas and less on, for example, a new pair of sunglasses.
Second, most retail traders are not incredibly flush with cash. FINRA reported that the median portfolio value of a Robinhood account is $240, and Personal Capital reported that the median portfolio value of an investor in their 30s is around $170,000. As such, fluctuations in gas prices can eat into monthly or annual contribution amounts, decreasing the amount of money put into the market.
Can Investors Use Oil Prices as an Indicator?
Because there’s no statistical correlation between oil prices and the broader stock market's performance, you need to look at additional factors in the current economic backdrop to predict how the markets respond.
If we are in an economic boom, where investment and consumer spending are rampant, increasing oil prices will not likely hurt the market. The benefit to revenues from a hot business cycle likely outweighs the costs of higher oil prices, meaning the stock market may continue a bull run despite rising oil prices.
Avoid using day-to-day oil price fluctuations as an indicator for overall market shifts. Even with large fluctuations in the oil prices, these changes are often reactionary to other geopolitical news that may better indicate a shift in the stock market. For example, if war broke out in the Middle East, both the oil market and stock market would react simultaneously, not one after the other.
Investors can more accurately use swings in oil prices as indicators for the transportation, oil and industrial sectors of the stock market.
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Are Oil Prices Predictive of the Stock Market?
Oil prices are not a robust sole indicator of how the market may move on a given day. In fact, the Cleveland Federal Reserve found no correlation between the day-to-day fluctuations in oil prices and the broader stock market. Industries that are highly exposed to oil prices, either as cost or revenue drivers (sometimes both), tend to correlate with changes in oil prices.
Frequently Asked Questions
Are high oil prices good for oil stocks?
Yes! Upstream companies see more favorable margins due to the nature of their cost structure. Midstream and downstream companies will also see a healthier bottom line, though the margin increase may not be as significant as that of an upstream company.
Which stocks are most affected by oil prices?
- The transportation sector (e.g., airlines and shipping)
- The oil industry — primarily those engaged in exploration and production
- The industrials industry — namely those whose business cycles are tied to investment in the oil sector