What is Crude Oil's Effect on the Stock Market?
A dominant source of energy in the economy, crude oil can both promote and hinder economic growth as changing oil prices interact with economic activities. The stock market, as a general representation of the economy, can respond quickly to trading moves in oil pits when looking for economic indications. Through price as well as demand, crude oil may affect the stock market either positively or negatively given how the economy is faring at the time.
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Crude Demand
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Because crude oil is a strategic commodity that the economy depends on, it's hard for the economy to tolerate high oil prices for very long. In a November 2007 "New York Times" article, Fatih Birol, chief economist at the International Energy Agency, conveyed the idea that prolonged high prices create affordability issues and eventually hurt both producers and consumers. On the other hand, oil prices don't stay low for any extended period in today's global economy, which is hungry for oil.
Market Cycles
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The economy and the stock market go through booms and busts for a host of economic and financial reasons, including effects from crude oil. In a bull market, investor demand drives up the prices of assets across the board, pushing aside cost concerns. A "Wall Street Journal" article on June 22, 2008, mentioned that higher fuel costs can be absorbed by consumers and businesses sometimes. But in a bear market, investor liquidation scales down the availability of resources, damping down demand along the way. For crude oil to have any impact on the stock market, it is by working through the market dynamics of rise and fall.
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Correlations
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When the stock market emerges from a trough, a low crude price benefits the market by reducing energy costs to the economy. When the economy picks up more oil demand, a rising crude price may lead to higher stock prices as supported by a healthier economy. But if oil prices keep rising and become unaffordable, the stock market retreats as costly energy uses eat into economic growth. In that case, even as crude oil falls, the stock market continues to trend lower before a new round of oil demand has yet to solidify. Crude oil's effect on the stock market is neither consistently negative nor positive. A 2008 study on the same topic from the Federal Reserve Bank of Cleveland underscored this point.
Market Speculation
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In addition to the easily observed effects from what consumers pay at the pump and companies buy on the spot, the seldom-admitted speculation in setting crude oil prices on futures markets has an impact on the stock market as well. For example, if oil traders suspect a positive outlook on the economy, they would most likely bid up futures prices and the stock market may take it as an affirmation of its own bullish belief, pushing up stock prices further.
Effect Limitations
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Change in crude oil price may not affect different stock indexes equally. Some companies in certain industries are exposed more than others to the rising and falling fuel costs. The Dow Jones Transportation Index has had a more negative correlation with crude oil price that is statistically significant at the 95 percent confident level, as shown in the 2008 Cleveland-Fed study. The broader the market goes, the lesser impact crude oil may have, a diluting effect of having a mix of companies from a wider range of industries.
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References
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- Photo Credit oil rig at sunset image by Alan James from Fotolia.com
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Comments
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