PMC Weekly Review - June 30, 2017

A Macro View – The Crude Reality: Do Oil Prices Predict Market Returns?
When the Organization of the Petroleum Exporting Countries (OPEC) meeting concluded on May 25 this year, oil prices finished down nearly 5% from their previous close. The sharp drop was due in large part to disappointment that production cuts did not go further. OPEC agreed to continue its previously pledged cuts of 1.8 million barrels per day for another nine months. However, the following day crude oil rebounded from the fall, and US West Texas Intermediate (WTI) crude futures finished up almost 2%, but still closed under $50 a barrel. Although the price of oil is up from its low of under $27 a barrel in 2016, it is still a far cry from its high point of around $160 a barrel in 2008. Yet, simultaneously, the S&P 500 continues to reach all-time highs. So what can be inferred from the relationship between the price of oil and stock market returns?

Since 1990, the correlation between the WTI and the S&P 500 has been around 0.56, indicating that as one increases, the other generally does as well. However, since 2014, when the price of oil fell significantly, the correlation has become negative, and the stock market continues to set new high records, while oil continues to fall from its high water mark. This is not the only instance where oil prices and stock market returns have decoupled. Low oil prices helped to precipitate the dotcom boom in the late 1990s, and oil remained high for a short period as stocks plunged after the financial crisis in 2008.

Generally, when oil prices dip, investors worry that there is less demand, ultimately indicating a slowdown in overall economic growth. Another concern they have is that domestic producers will default on their loan payments, hurting banks that have provided loans to oil-related companies and further dragging down the economy. However, in the current environment, the consensus remains that low prices have more to do with the supply side, as global demand for oil continues to increase around 1.3% annually. After an uptick in American shale oil production, OPEC responded by increasing production to retain market share. OPEC also has issues with its ability to enforce production cuts on its member nations: Its current pledged agreement to cut production doesn’t even include Libya or Nigeria, who account for 7.1% of OPEC’s production. After American production slowed in 2015, the industry as a whole reorganized by improving technology and becoming more efficient. Ultimately, much of the US oil industry became profitable, with oil prices under $50 a barrel, and continued to add to the world’s supply, which in turn has kept prices low. 

Concurrently, the stock market has continued to make gains alongside low oil prices, due in part to the weight that energy companies carry within our economy. After oil prices dropped precipitously in 2008, the Energy sector consolidated and currently constitutes 6% of the S&P 500, much less than the 15% weight it had before the decline. Energy is a main cost of almost any production, and although low oil prices have been harmful to energy companies, low oil prices have benefited the main driver of the American economy, consumers. Low oil prices have essentially served as a tax cut for much of America, allowing more dollars to flow to other economic sectors.

So what does all this mean for using oil prices as a proxy for the US economy? It’s hard to point to any single indicator to predict where the market will go; not only are sectors intricately intertwined, but a multitude of factors coalesce to determine market performance. As we have seen, despite a positive historical correlation between oil prices and market performance since 1990, market performance depends heavily on the time period being reviewed. Technological advances, increased efficiency, smaller market representation, and an increase in global production and supply all seem to have the energy sector in a transitional period. Regardless, it appears low oil prices have become the new norm, which should continue to benefit many areas of the economy while harming others, further complicating the relationship between oil prices and stock market returns.

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