Why the rising oil price isn't bad news for stocks
By
Dominic Frisby Jun 22, 2009
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The 2005 book Freakonomics, by Stephen J Dubner and Steven D Levitt, demonstrated how often the obvious, logical, generally accepted explanation for things is not the correct one.
For example, it argued quite convincingly that New York's falling crime rate had less to do with Mayor Giuliani's 'zero tolerance' policy and more to do with a decline in the male teenage population, due to new abortion laws made half a generation earlier.
So now let's look at a similar, conventional explanation about oil prices and the stock markets. A higher oil price means higher operating costs and thus lower profits – unless you are an oil producer – so it follows quite logically that 'a high oil price is bad for the economy' and, by extension, the stock market. In fact, it's one of the most prevalent received economic wisdoms.
But is it actually correct?
Is a high oil price bad for the economy?
Our first chart shows the price of oil and the S&P over the last 200 days. There is an uncanny correlation between the two. From its February low below $35 a barrel, the oil price has more than doubled this year, closing last week at $70 per barrel. This surge has coincided with a spring bull market in stocks. One is a virtual mirror of the other. Oil collapsed with the bust and has rallied with the subsequent boom. In fact, it has led the boom.
The force of this stock market rebound has led many to now declare that the economic crisis is over. The initial panic is certainly over. The stock market has rallied, the housing market has rallied, the Baltic Dry Shipping index has rallied, the banking system is no longer frozen. If a high oil price is bad for the economy, it seems surprising that this recovery has taken place in the environment of a rapidly rising oil price.
Perhaps this recent correlation is an aberration? Well, let's take a look.
Nick Laird of www.sharelynx.co.uk has put together some charts showing the relationship between oil and the stock market over the last century. The blue lines show stocks, the black oil. Let's look first at the decade from 1927 to 1938.
Just as we've seen in the recent rally, one is a virtual mirror of the other. Sometimes one was ahead of the other, as in 1931-2 and 1935, but for the most part oil rose with the boom and fell with the bust. Now let's look at the 1970s.
There is a huge divergence in 1973-4, when oil cartel Opec proclaimed an oil embargo in response to the US decision to re-supply the Israeli military during the Yom Kippur war. Oil rallied enormously and stocks, already declining, collapsed. So in this case, the high oil price knocked out an already-hurting economy.
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But within a year the stock market had rallied. For the rest of the decade until 1979 the oil price was pretty flat at just below $15, while the stock market also moved sideways. In 1979 stocks and oil rose together (though oil rose more impressively); stocks peaked in late 1980, oil just months later; and then the two fell together. Though of differing magnitudes, it's worth noting that the subsequent bear market rallies also coincided.
Let's look now at the 1980s.
There are two big divergences. The collapse of oil prices in 1985-6, caused by the sudden increase in Saudi production. Secondly, there was the spike in oil in mid 1990, a consequence of the first Iraq war, which also caused a decline in stocks. But for most of the rest of the decade, though of differing magnitudes, rises and falls in price of both coincided.
Even though oil was in a bear market during the 1990s, while stocks were in a bull market, rallies and falls still coincided during this decade. The major exception to this is 1997-8, when the oil price collapsed amid the Asian economic crisis (although Asian markets collapsed with oil, so no divergence there).
Finally, we look at the period from 1997 to the present day. With the exception of the divergences of late 2006 and early 2008, oil and stocks rose and fell together.
So, apart from occasional large divergences caused by outlier events, such as war, history suggests that the oil price rises with the boom and falls with the bust. This would not happen if 'a high oil price is bad for the economy'.
The price of oil is a symptom
I believe that you need to look at the oil price not as a cause, but as a symptom. A rising oil price is a symptom of more money and credit flowing through the economy, and of more demand, be it real or speculative. It's a sign that, although business costs may be higher, turnover is also greater – a falling oil price, on the other hand, is a symptom of economic contraction.
There have been occasions, such as 1973, where the unprecedented oil price spike coincided with a recession and had devastating economic consequences. And there are of course companies and sectors such as airlines, which are leveraged to the oil price. But for the most part a rising oil price tells you that, actually, things are going rather well.
What does the future hold for oil?
So what does this suggest for the future direction of oil?
If you believe the economic downturn is over and that this recent up-move is the start of a major new bull market, then the oil price is most likely headed higher. If, like me, you believe that this across-the-board rally has been nothing more than a corrective bounce in an ongoing bear market – and that markets are about to head south – then oil is headed lower.
I do, however, subscribe to the Peak Oil theory that world oil reserves are depleting. This will take many years to unfold, but as oil becomes more and more precious – and assuming no new energy source is found to replace it – a possible scenario is that oil will outperform general markets during up-moves and not be hit quite so hard during the downturns. But next time you hear a pundit saying a rising oil price is bad for the stock market, do send him a link to this article.
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by
Dominic Frisby
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