Oct 14, 2019 Equities

Could the stock market start to slide? How the oil price affects equity markets

The attack on Saudi Arabian oil facilities in mid-September catapulted the oil price upwards for a time. Equity investors were also alarmed. Were they right?

  • Oil is and remains the lubricant for the global economy. The oil price has considerable influence on economic growth.
  • As well as the absolute price level, the oil price’s rate of change is crucial. Short-term oil price fluctuations can spill over into equity markets.
  • However, a higher oil price isn’t necessarily bad for equities, and a lower price isn't always good.
4 minutes to read

The shock was deeply felt; following the attack on the world's largest oil processing facility in Saudi Arabia, in mid-September market fears spread that oil supplies from the Gulf region could be disrupted for quite some time. Worse still, if tensions were to escalate to all-out war, supplies from the Middle East – one of the world’s most important areas of production – could dry up completely. No wonder that the first reaction was for the price of this black gold to soar by almost 20 per cent for a time – the sharpest increase in the oil price since the Gulf War at the start of the 1990s.

Global dependency on oil may have dropped somewhat – but it is still high.

Higher oil prices put a strain on the economy

Equity markets were not unaffected by the uncertainty on the oil market, with prices coming under temporary pressure. Investors were afraid that sharp oil price rises could put the brakes on economic growth, dampening business prospects for many industries.

Despite advances in renewable energy, it’s clear that the economy is still largely dependent on oil for its energy needs.

Oil’s influence on the energy and transport sectors is particularly obvious. While oil companies and their suppliers – manufacturers of production equipment, for example – benefit from increasing oil prices, higher fuel costs put a squeeze on the earnings of logistics companies and airlines.

The extra money that consumers must spend on petrol and oil for heating (or natural gas, which is tied to the heating oil price) also cannot be spent on other areas.

Manufacturers of cyclical goods (i.e. non-vital goods), such as the car and fashion industries, feel the pressure and then have to adjust their business plans. This means higher oil prices have a knock-on effect on different sectors, although it’s safe to say that direct oil price effects have reduced since the 1970s.[1]

Central banks could apply the brakes

We also shouldn’t forget indirect effects on the economy and equity markets. As higher oil prices are eventually reflected in inflation, central banks may feel compelled to tighten their currently very loose monetary policy. And even the prospect of rising interest rates is generally toxic for equity markets.

Higher oil prices have a knock-on effect on different economic sectors.

There isn’t just one type of oil, but many different quality standards. Brent and WTI (West Texas Intermediate) are the best-known.

That's the theory at any rate. But in reality, there has been evidence that the relationship between the oil price and share prices isn’t as clear as all that. There have been repeated phases in the past when both markets moved in the same direction. In 2010, for example, oil became about 20 per cent more expensive, and global share prices nonetheless rose by about 10 per cent. So, the oil price is just one factor among many that influences share prices. Experience shows that when conditions are otherwise right, rising oil prices do not perturb investors.

Autumn 2018 provides an impressive example of the reverse scenario when both oil and equities were weak. Back then, investors interpreted the oil price’s development as a sign of growing weakness in the economy that would lead to negative corporate earnings performance. The expected economic stimulus from low oil prices was not enough to generate an upturn in stock-market sentiment at that time.

Possibility to adjust

There does not seem to be a relationship between oil prices and share prices that generally applies. However, alongside absolute price levels, the speed at which prices change on the oil market remains a crucial factor. Here it’s a case of the slower, the better because companies and consumers then have enough time to adjust to the new situation. In any case, investors should not assume that a higher oil price is necessarily bad for equity markets or allow themselves to get caught up in any panic on the oil market.

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1. https://www.kfw.de/PDF/Download-Center/Konzernthemen/Research/PDF-Dokumente-Fokus-Volkswirtschaft/Fokus-Nr.-94-Juni-2015.pdf, P.1, first column, second paragraph

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