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If you ask a layman about the relationship between the price of oil and the stock market, the expected answer would be: “The relationship is negative.” This kind of view is also shared by the financial press. But in reality, this relationship is much more complicated than this simple answer. It depends on the circumstances and the prevailing state of the macroeconomy. In a certain circumstance, the relationship is positively causal and there is a leader and a follower, and the problem is to figure out which one is the leader. In another circumstance, the leading/lagging relationship is negative. In these circumstances, the leader could be either the stock market or the oil price. It is not surprising if the leader is the stock market because this economic variable is one of the 11 leading indicators that make up the Leading Economic Indictors Index, which is supposed to lead the economy by six-nine months. The oil price is not one of those indicators and can generally be considered a coincident indicator. But certain powerful shocks in the oil market can move the stock market and make the oil price the leader.

In most of 2008-09, which is the center of the ‘Great Recession’, the stock market has been the leader and the oil price is the follower. There have been no strong shocks in the oil market during this period. The oil price has been fundamentally blind and divorced itself from its physical supply and demand because oil is not only a fuel but also an investment commodity. The oil market has been plagued by a sizeable glut and the oil producers have sustained an excess capacity of more than 5mn b/d. The oil fundamentals have given the oil price a thumb down, but this price ignored this strong downward signal because it has another role and looked ahead. As blinded by its fundamentals as it is under the current circumstances, the oil price followed the stock market to guide its way through the future. The stock market has been running forward, rising from 6,548.05on the Dow on 9 March 2009 to more than 10,000, a gain of more than 53%. It is the oil traders, hedge funds and exchange-traded funds (ETFs) but not the refiners or physical players that raised oil price from $32/B in December 2008 to more than $80/B recently. The stock market, which moves six-nine months before the economy, has been predicting recovery in the third quarter of 2009. The oil market processed this information and acted on it. The financial players seized this information and acted on it. Those players also looked at collaborating factors and found it in the depreciating dollar, as will be explained later.

But this oil price/stock market relationship with an eye on the dollar is not a one-way street, particularly when recovery has been felt and become within reach. The physical and financial players have had a sequential look at the oil price to discern any reinforcing information that confirms or supports the lead of the stock market. A week’s drawdown in oil and refined products inventories is weekly examined and has been clued as a rise in demand for oil. In this reinforcing machination, the drawdown is used to bestow higher prices on oil and oil companies’ shares, consequently moving up the stock market. In another connecting channel, the strengthening of oil demand is viewed as an increase in consumer spending which makes up 70% of the overall economy. In this round, the leading indicator (the stock market) gets its clues from the oil price and marches up, along with other commodities. It is not surprising that on 16 October 2009 a headline in Wall Street Journal read “Oil Lifts Dow To 10,062.94.” This time oil price is the leader.

In many of these bi-directional relationships, the confounding factor is the US dollar. Oil price moves in opposite direction to the change in the value of the dollar. A depreciating dollar implies an increase in the price of oil even against unsupporting oil fundamentals, because oil is an excellent financial play on the value of the dollar. Being a currency commodity, oil moves faster than other hard assets. So if the stock market moves up and the dollar depreciates the price of oil will likely shoot up, despite its bad physical fundamentals. If the dollar appreciates while the stock market is marching up, the direction of the oil price is uncertain.

Recent research has shown that we should decompose the changes in oil price into three shocks – aggregate demand (reflecting global economic expansion) shocks, oil market specific demand (oil idiosyncratic) shocks, and oil supply (oil production) shocks – and trace the impacts of those types of shocks on stock returns.¹ The impact on stock returns is positive if the oil shock originates from changes in aggregate demand.² Rising economic tides raise all boats. On the contrary, higher oil prices driven by an increase in precautionary demand out of fears of future availability of crude oil would have a negative impact on the oil price. This circumstance reflects strong fears, concerns and risk in the world economy. This is the kind of shock that is on the minds of the layman and financial press. Finally, a decrease in oil supply in one country may be offset by an increase in another, making this oil supply shock of minimal importance in the short run. Therefore, the source of the oil price change is important, and the oil demand shocks are much more powerful in affecting stock market returns than the oil supply shocks, particularly on monthly basis.

If we trace the different oil shocks to the industry level, research has shown that industry specific stock returns display different sensitivities to the three oil shocks. Stock returns of the oil and gas industry and the gold and silver mining industry show positive responses to the oil market specific demand (idiosyncratic) shock. There is an increase in precautionary demand for oil and gas at times of high uncertainty about future availability of those fuels. In such an environment, there is also a movement towards the safe haven of gold and silver. The automobile and retailing industries show negative responses to the oil idiosyncratic shock, which points to rising risk in the oil markets.

If the oil shock is sourced from aggregate economic expansions, the automobile, retailing and tourism (restaurants, hotels, etc) industries would show strong positive response to the aggregate demand shock. This is a case of rising economic tides raising all the boats.

In an advanced stage of strong economic expansions, increases in the oil price are seen inflationary for the whole economy. Our recent research shows that higher oil prices would increase the general price level, and basically the prices of all commodity groups (as classified by the IMF) including food, beverages, industrial inputs, agricultural raw materials and metals. The highest negative impact falls the most on beverages, metals and industrial inputs. This is negative to the overall economy and the stock market. This brings us back to the layman’s answer and the financial press.

Shawkat Hammoudeh is Professor of Economics and International Business at Drexel University. He can be reached at hammousm@drexel.edu. Petroleumworld not necessarily share these views.

Editor's note:This article was first posted Middle East Economic Survey ( MEES), VOL. LII, No 49, 16-Nov-2009. Petroleumworld reprint this article in the interest of our readers. All comments posted and published on Petroleumworld, do not reflect either for or against the opinion expressed in the comment as an endorsement of Petroleumworld.

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Petroleumworld News 11/25/ 09

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