Volatility, in both stock and commodity markets, inevitably raises a variety of questions. Following the brutal selloffs in the past week, both oil prices and the market as a whole have suffered. As WTI crude oil prices have fallen to their lowest levels in over 6.5 years and a precipitous drop in the Dow and S&P 500 has sparked fears of a broader market decline, investors are seeking to understand the relationship between the two. Aren’t oil price collapses an indicator of weakness in financial markets? Or should we expect low oil prices to act as a global economic stimulus? What about China’s impact on oil prices and the global economy in general? In short, what is the relationship between oil prices and the health of the stock market?
With so many conflicting factors, it’s worth parsing out the individual components of how oil prices drive the stock market, and vice versa, and where correlations do (and don’t) exist.
On a long enough timeline…
Oil is one of the single most crucial inputs into the global economy, and the relationship between oil and the stock market is complex. Earlier this year, Barclays examined the correlation between oil prices and the stock market over the past two decades. If 1 represents a perfect positive correlation, and -1 is a perfect negative correlation, and 0 means no correlation, Barclays found a correlation of .25 between Brent crude oil prices and the S&P 500. Once removing the financial crisis, when oil prices and financial markets both collapsed, that correlation dropped to .16—basically no correlation at all.
But the analysis from Barclays didn’t examine how the relationship between oil and stock prices has tightened in more recent years, and the two markets are more connected in a number of ways. First, more and more financial players are focusing on commodities in addition to stocks and currencies—a shift that occurred partially due to the instability of worldwide financial markets following the financial crisis, leading many to view physical commodities as a safe haven for investors, particularly as a hedge against inflation and geopolitical risk. Second, quantitative easing increased the links between the stock market and oil prices, as both rose together following the 2008 crash as a result of strengthening economic growth.
In the period since 2008, the correlation between the S&P 500 rose from .29 to .77, reflecting the tighter relationship between crude prices and stock movements.
Our own analysis of the r-squared value between WTI crude oil prices and the S&P 500 found that in the period from 2000 to 2008, the correlation between the two was .29—consistent with the figures published by Barclays, and nothing to write home about as correlation coefficients go. However, looking only at the period since 2008, that value increased to .77, suggesting a much tighter relationship between crude prices and stock movements.
Meanwhile, oil markets and stock markets do have one thing clearly in common—volatility sweeps through both indexes at similar times. The chart above shows this is a 30-day moving average of the standard deviation in the normalized prices of both indexes—a way to measure volatility, which frequently affects both in tandem—not always, but certainly with greater tightness post-financial crisis.
Oil company stocks vs. broader corporate earnings
With oil prices so low, conventional wisdom sees two counterbalancing factors.
Share prices of the global oil majors are all down between 30 to 45 percent since last year. Shale producers have also dropped 33 to 46 percent.
Obviously, low oil prices hurt oil producing companies. Share prices of the global oil majors (below, from left to right, Royal Dutch Shell, ExxonMobil, BP, Total, and Chevron) are all down between 30 to 45 percent since last year. Shale producers (below, EOG Resources, Pioneer Natural Resources, Continental Resources, Cabot Oil and Gas, Noble Energy, Anadarko Petroleum) have also dropped 33 to 46 percent.
Out of the S&P 500 Index, 40 companies—or 8 percent—are oil and gas companies. It’s worth noting that a small number of those (Phillips 66, Spectra Energy, Marathon Petroleum, Valero Energy, and Tesoro Petroleum) are refiners rather than producers, which means that low oil prices are a significant benefit for their bottom lines. However, while poor performance from oil producers might be weighing down the market to a small extent, the dramatic drops in the past week are across the board. Oil and gas companies are in a particularly perilous situation because with WTI crude oil now in the $30s and unlikely to recover in the near term, the pain they have already suffered could be just the beginning. But oil’s dropoff is not responsible for what’s happened across the major stock market indices.
For most companies, the benefits of cheap fuel should not be underestimated. Consider the airline industry. In 2012, when oil prices were locked into the $100 range, airlines were paying more for fuel than for salaries. An analysis cited in the Wall Street Journal estimated that on a 100-passenger US Airways flight, 29 percent of revenue from tickets and fees were used to cover fuel costs. For the most oil-intensive industries (airlines, shipping, trucking, etc) the collapse in fuel prices creates tremendous upside for their bottom lines. This direct benefit is shared by chemical manufacturers who depend on petroleum as a primary feedstock.
In 2012, when oil prices were locked into the $100 range, airlines were paying more for fuel than for salaries.
But the benefits aren’t isolated to companies that depend heavily on oil as an input. Retailers benefit because consumers are saving money on gas and therefore have more for discretionary spending. The travel and leisure industries also experience a bump.
China wreaking havoc
China’s stock market and yuan devaluation are some of the biggest drivers behind the selloff in U.S. markets. But while the perception of weak Chinese oil demand is one of many reasons that oil prices are so low, China’s demand for oil is currently the highest it’s ever been, and continues to grow. Chinese oil imports are up 22 percent in July since last year, and Citibank pegs Chinese oil demand growth at 7 percent this year. Still, the expectation of a “hard landing” for China’s economy is currently priced into oil markets, even as the country continues to buy massive volumes to fill its strategic reserves.
China and investor perceptions of China are a current example of a force driving volatility through both oil and stock markets simultaneously. Volatility in both markets is nothing new, but that doesn’t mean that wild swings in oil prices don’t have significant and occasionally destructive impacts on the broader economy.