Oil prices and the stock market do not usually trade as a highly correlated pair, but since the beginning of 2016, the S&P 500 and crude oil prices have been moving in lock-step with one another. Why have these disparate markets that have historically moved independently become so closely related?
The answer appears to be the perception that the price of oil is serving as a barometer to measure the health of the U.S. economy. When oil prices are declining, the perception is the economy is contracting and the market sells off. On the other hand, rising oil prices are seen as a positive sign for the economy.
The problem with this perception is that demand is not the prevailing issue for oil prices. Demand for oil, while experiencing some brief declines, has increased steadily since North Sea Brent Crude started falling from its June 2014 high of $112 per barrel. Eighteen months later, as of Feb. 29, 2016, Brent sits at $35.97 because the driving force in the price equation for oil is the supply, as producers have either maintained or expanded production in the face of falling prices.
This has been a surprise for many because price declines are usually met with production cutbacks in standard economic scenarios. Instead, production has continued at the same pace for several reasons.
1) Saudi Arabia and Kuwait can extract oil for less than $10 per barrel. In Iraq, the cost of producing a barrel of oil is less than $11. With prices in the mid-$30s, these producers can still profit from every barrel but they must extract more oil to maintain main cash flows.
2) Profitability allows low-cost producers to put pressure on new and/or highly leveraged shale oil companies in Canada and the United States with higher breakeven points. The objective of applying this pressure is to push these companies and their oil production out of the market.
3) Due to the cost of stopping and starting production, particularly in shale oil fields, it is more cost effective for some companies to continue pumping, even if each barrel is extracted at a loss.
4) Highly indebted producers have to sell oil to service their debts. Under these circumstances, producers are trying to keep their creditors at bay while maintaining control of their companies, rather than defaulting on their loans and filing bankruptcy and being taken over by their bondholders.
The reason the stock market and oil prices are generally uncorrelated is that the pricing mechanisms are different. The stock market usually trades on fundamentals, including earnings, revenue growth, price/earnings (P/E) ratios and a host of additional metrics. As a commodity, the price of oil is determined based on supply versus demand.
Since the beginning of 2016, oil prices have been seen as a sentiment indicator for the economy, which has linked the two markets in a highly correlated relationship. Oil prices, however, are not providing an accurate picture of the economy due to the variety of agendas that require the pumping of oil in an already saturated market.
What lower oil prices are doing is putting more money into the pockets of consumers. Spending will likely help the economy as well as the stock market over time, regardless of how long oil prices chug along in the $30 to $40 range. Should that scenario occur, the stock market and oil prices will likely decouple and resume their historically uncorrelated relationship.