The existence of a correlation between oil pricing and stock market valuations have been a point of contention among economists, academics and traders for decades. Conventional financial wisdom alludes to the presence of a definite correlation between oil and stock price. Contrarians to this idea have stated that oil and equities complement one another on a cyclical basis, if at all.
The complexities of this link have been scrutinised for years. Authorities such as the International Monetary Fund (IMF), Bank Of International Settlements (BIS), U.S. Energy Information Administration (EIA) and the U.S. Federal Reserve (FED) have examined the topic extensively. Conclusions range from the presence of a strong correlation to no correlation whatsoever.
These results are not surprising because discrepancies in each study's duration, inputs and methodology have built subtle biases into the outcomes. As with most things in the financial arena, the truth is likely to fall somewhere in the middle.
Types Of Crude Oil
The term "crude oil" is a catch-all term to describe products on the global oil markets. However, it's important to understand that there are multiple types of crude oil, each unique in constitution and pricing. Although historical market data suggests that there may be correlations between stock and oil prices, the relationship varies in relation to the product being referenced.
According to the U.S. Environmental Protection Agency (EPA), crude oil is "a mixture of hydrocarbons that exists in liquid phase in natural underground reservoirs and remains liquid at atmospheric pressure after passing through surface separating facilities." The EPA outlines four different types of crude oil:
- Class A: Light, Volatile Oils: Class A oils are fluid, transparent and flammable. These types of oils are ideal for refinement and are considered to be the highest-quality light, sweet crude. Class A oils are the key component in the production of gasoline, diesel and heating oil.
- Class B: Non-Sticky Oils: Class B oils are waxy and less toxic. These types aren't featured in the production of refined fuels.
- Class C: Class C oils are viscous, sticky and dark in colour. Lower-quality crudes are considered Class C, such as heavy crude oil or Canadian bituminous oil sands.
- Class D: Class D oils are non-toxic and dark brown or black in colour.
Class A crude oils are the underlying asset for the price of oil. This class contains light, sweet crude, which is easily converted into refined fuels. Although significant oil production may be attributed to lower grade products such as bituminous oil sands, higher quality crude is a more desirable commodity.
Crude oil derivatives are commonly traded in the form of futures contracts and CFDs. The key products facing the global oil complex are WTI and Brent crude oil. The pricing of these assets serve as the basis for any correlations between oil and stock prices.
West Texas Intermediate (WTI)
WTI crude oil futures are the benchmark contract for the trade of light, sweet crude oil. Listed for trade on the Chicago Mercantile Exchange (CME), WTI futures are the world's most liquid oil derivatives contract. Technically a listing of the New York Mercantile Exchange (NYMEX), WTI futures are electronically traded in real-time on the CME Globex exchange.
Due to WTI's influence, the USOIL CFD is popular among traders around the globe. Thus, most analysts reference the price of WTI when making assertions concerning economic growth or rising gas prices.
North Sea Brent (Brent)
North Sea Brent futures are widely accepted as being the go-to reference for the price of international crude oil. Discovered and cultivated in the North Sea above Northwestern Europe, Brent crude is a desirable oil for refinement.
Brent futures are traded on the Intercontinental Exchange (ICE). Although Brent crude oil doesn't see the participation of WTI, it remains a popular product among energy traders, investors and producers. Contract for difference traders look to the UKOIL CFD to gain exposure to Brent crude pricing.
Influence Of WTI And Brent
The WTI and Brent markets have a significant reach throughout the world of finance. In fact, the price of crude oil directly impacts companies local to the oil industry, as well as those that require refined fuels to operate. The interrelationships surrounding oil span the travel, agricultural and logistics sectors.
On Wall Street, the oil trade has a profound influence on companies local to the energy industry. Known as oil stocks, these firms specialise in oil exploration, production, oil field services and refinement. A few examples of oil stocks are Shell (SHEL), Exxon Mobil (XOM), British Petroleum (BP), Halliburton (HAL) and ConocoPhillips (COP).
Aside from purchasing shares outright, the NASDAQ offers a collection of oil ETFs to active traders. These listings are diverse and give traders and investors a way to invest in oil companies, or take long or short positions to profit from crude oil market volatility.
Supply, Demand And Monetary Policy
As a commodity, crude oil pricing is dependent on three factors: supply, demand and the value of the U.S. dollar. At any given time, these three inputs can sway oil prices rapidly and dramatically.
The world's supply of crude oil relies on many different regions, nations and affiliations. As of 2016, there were 1.65 trillion barrels of established oil reserves. A majority of these reserves are located in five countries: Venezuela, Saudi Arabia, Canada, Iran and Iraq. According to the Organisation of the Petroleum Exporting Countries (OPEC), 79.4% of all proven oil reserves reside in OPEC nations.
Many factors can influence the world's supply of oil. Armed conflict, policy shifts from OPEC, governmental restrictions and even oil spills are all capable of impacting supplies. Generally, when oil supplies grow, prices fall. And when supplies fall, the result is higher oil prices.
Crude oil is an essential input of economic growth. However, global demand levels fluctuate according to season, economic cycle and unexpected events. As demand grows and shrinks, oil prices exhibit volatility.
Historically, oil prices have exhibited sensitivities to the seasons of the Northern Hemisphere. As a general rule, oil prices heighten during peak demand for refined fuels and fall during periods of reduced fuel consumption. Subsequently, winter in the Northern Hemisphere leads to lower oil prices, while summer produces higher prices. This tendency is opposite of natural gas, which is prone to bullish winter pricing.
The March 2020 onset of the COVID-19 pandemic created a historic plunge in global demand. As the world shut down, demand from major consumers such as China, Russia, the U.S., U.K., EU and Japan plunged. An oil supply glut ensued and WTI prices hit a historic low of -US$40.32 per barrel.
The global oil complex relies on the petrodollar system of pricing. Under the petrodollar, the oil is denominated in United States dollars (USD). No matter where someone buys or sells a barrel of oil, the transaction is valued in terms of the USD.
The petrodollar system places an extra impetus on the stability of the USD. Thus, monetary policies of the U.S. Federal Reserve (Fed) impacts oil prices. For instance, when the Fed lowers interest rates, oil prices are likely to rise in anticipation of a weaker USD. Conversely, when the Fed raises interest rates, oil prices are likely to fall, reflecting a perceived stronger USD.
Monetary policy can greatly alter oil and all commodity prices. In turn, sectoral stock prices may be influenced, as well as the broader equities market.
When it comes to the relationship between oil and stock pricing, conventional wisdom states that the two have an inverse correlation. In simplest terms, the relationship is as follows:
- As oil prices rise, equities valuations are driven down
- As oil prices fall, equities valuations are driven up
The underlying assumption adopted by this view is that when oil prices rise, energy prices rise as a whole. This causes systemic inflation, increasing the sunk costs absorbed by companies during the execution of everyday business operations.
In turn, profitability is hurt. As a result, traders and investors are prompted to sell off corporate stock and drive share price down.
So, does the conventional wisdom on the subject hold true? The answer is an indecisive yes and no.
In an observational study conducted by Forbes, possible correlations between the Dow Jones Industrial Average (DJIA) and crude oil pricing from 26 December 1990 to 25 January 2011 were looked at in depth. The following patterns in pricing behaviour were noticed:
- From 7/1/1997 to 16/2/1999 oil and stocks had a negative correlation of -0.84
- From 19/2/2009 to 27/4/2011 oil and stocks had a positive correlation of +0.94
- Several prolonged periods of no correlation between -0.30 and +0.30 were observed
- An aggregate positive correlation of +0.69 was present
The results of the investigation show a moderate correlation from 1991 to 2011, with periods of considerable positive and negative correlations. In effect, the exercise illustrated conventional wisdom holds true at least some of the time.
A similar examination of the subject was conducted by the Brookings Institution, led by former U.S. FED chairman Ben Bernanke. Although somewhat-volatile, a positive correlation between WTI Crude Oil pricing and the S&P 500 from June 2011 to December 2015 was observed. Essentially, as the price per barrel of WTI crude oil rose, so did the S&P 500.
Interpretations And Conclusions
Seemingly several times every year the oil/stock price analogy is revisited by academia. In the midst of a large rally or the pronounced selloff of an equities indices, energy pricing is a favourite culprit. Promoting dependency between the two asset-classes is a pastime enjoyed by industry analysts and journalists.
At least for now, a consensus has not been reached. The results of formal studies are often contradictory and depend greatly on guiding parameters. Listed below are several factors that substantially influence the outcomes of any study based on market-related data.
- Sector, indices or individual stock used as reference: In the above examples, a study of oil and the DJIA showed periods of negative correlation. Conversely, an exercise based upon the S&P 500 was used to illustrate a positive one.
- Duration of the study: The length and historical timeframes used are crucial to the eventual outcome.
- Broader economic conditions: Macro and sectoral economic performance is a crucial component to any perceived oil/stock price relationship.
Drawing definitive conclusions from studies based upon historical data analysis can be a challenge. It is important to recognise the role that pitfalls such as hindsight bias and data fitting can present to objectivity.
Proving or disproving a correlation can be a tricky business. There are many factors to account for, and often no obvious answer is present.
When it comes to the relationship between oil and stock pricing, at least a moderate correlation does exist. It is often cyclical and can be either positive or negative. The relationship is dependent upon any number of factors and can vary wildly.
If one is to engage the capital markets based on the oil/stock price link, it is crucial to keep the perspective as current and objective as possible.
Past performance is not indicative of future results.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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Retrieved 27 Sep 2017 https://www3.epa.gov/carbon-footprint-calculator/tool/definitions/crude-oil.html
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