Why The Stock Market Likes Cheap Oil

To listen to the talking heads on TV over the last few months you would think that there is a direct positive correlation between oil prices and the stock market. "Stocks fall as oil price decline continues" and "Stocks follow oil lower" or even "Markets bounce back as oil halts decline" have been common refrains. The implication is that lower oil prices are bad for the stock market, but in reality that could not be further from the truth. Historically speaking, the correlation between oil and stocks is around 20%. In other words it is virtually non-existent. If anything, logic tells us that lower oil prices, and particularly this drop, should be a buy signal for equity investors.

For sure, there have been times when a sharp drop in oil has heralded a period of stagnation or declines in stocks. For example, in the twelve months following the 1985 oil collapse the S&P 500 lost around 1%. On the other hand, one year after the 1998 low in WTI the S&P 500 closed over 8% higher. The fact remains, though, that recently stocks have followed oil. The obvious question is "why?"

In general, currencies and commodities are the most sensitive markets to prospects for global growth. For this reason when oil falls stock traders have been conditioned over time to sell first and ask questions later. If there is any chance that a slowdown is coming it is better to be safe than sorry. In recent years that tendency toward an immediate correlation has been exaggerated by the advent of algorithmic trading. Computers react to price moves without consideration for the reasons behind those moves.

When we look closely at those reasons, however, it becomes obvious that this time around the benefits of lower fuel costs will easily outweigh any fear. Undoubtedly there was some concern about slower growth in China and a deflationary environment in Europe that contributed to the dramatic fall in oil, but both of those fears have subsided somewhat. The principle reason that oil halved in price was because of massively increased supply.

Technological advances, not just in the well publicized fracking for shale oil but also in deepwater drilling, have opened up previously unavailable reserves of oil all over the world. According to the U.S. Energy Information Administration (EIA), global supply increased by twice as much as demand from 2013 to 2014. That continues a trend that has been in place for a few years and has seen the world shift from an energy shortfall to a surplus. Once storage facilities began to fill again a drop in price was inevitable, even as demand continued to increase.

Without excessive concerns about global growth, lower oil prices, and therefore lower fuel costs, are a huge benefit to corporations outside the energy industry. Lower fuel costs in manufacturing, transport, retail and almost every imaginable sector will increase margins and free up capital for investment. Lower gas prices will encourage people to drive more, improving the outlook for auto companies and hotel operators. More car sales will increase demand for steel, aluminum and parts. The list goes on.

Lower oil prices are not without disadvantages. They discourage investment in cleaner alternative energy sources, for example, but to sell stocks in general on a fall in oil prices caused by a supply shock is folly in the extreme. Now that the initial panic has passed, both logic and history suggest that the stock market will come to love lower oil, and new record highs in the major indices look to be on the cards.