Oil and Stocks Are Joined at the Hip – The Real Reason Why, and What It Means for You
It used to be that the price of oil and the markets as a whole were disconnected.
But these days, it seems like they are instead dancing in unison. When oil goes down, stocks go down right with it.
There is no shortage of suggestions why.
In fact, every pundit appears to have a ready reason (or reasons) why the two are now joined at the hip. And in each case, the rationale points toward some fundamental factor underlying both.
Unfortunately, none of them explain what is really going on.
The real cause is quite different… and it’s a cautionary tale for anyone investing in energy…
1. Falling Oil Prices Do Not Signal a Global Slowdown
The first “hypothesis” is the one heard most often these days: it’s the economy, pure and simple. This approach suggests that falling oil prices are actually signaling a global economic retrenchment. According to this argument, economic declines worldwide are translating into anticipated cuts in oil demand.
Some are even moving further, claiming that the oil plunge is presaging an international depression.
The problem with this logic is itself straightforward. First, despite concerns over China and other economies, aggregate energy demand is actually increasing. Pundits continue to spread a basic misunderstanding about the real impact of recent market trends.
Global economic strength is hardly dependent upon China having to show a 7% annual growth rate. What is crucial in this regard remains the following: global aggregate markets are continuing to expand, while overall energy demand worldwide increased almost 3% last year, with 1.8% of that increase accounted for by oil alone.
In other words, there is no statistical basis for believing that declining oil prices are a harbinger of a collapse to come.
Indeed, the traditional result has been quite the opposite. Lower energy costs have generally translated into better (read: “cheaper”) economic performance for broader markets.
That brings us to a second proposed explanation…
2. The Energy Debt Crisis Has Not Crossed Over the Markets
This second factor is the rising energy debt problem. The debt in question here is the high end of the high-yield curve (i.e., “junk bonds”), the interest on which is now spiking at well over 17.5%.
|Editor’s Note: Kent recently wrote that about how you can find the best oil and gas plays amid the growing debt crisis in energy here.|
I’ve addressed this rising debt crisis as a major problem for U.S. oil companies in several past issues of Oil & Energy Investor.
In short, as the price of oil has fallen, oil and gas production companies will increasingly struggle to pay back their loans. And with increasing yields, covering old loans with new debt is more and more costly.
The argument here is that this energy credit crunch is resulting in a downward pressure for the markets as a whole.
Yet for the impact energy debt has on some select exchange-traded funds (ETFs) and notes (ETNs), it remains a minority portion of the debt curve as a whole. For the argument here to hold, the worsening outlook for energy debt must be constricting the ability of banks to extend credit to other businesses.
But there is simply no indication that this is happening.
Yes, the increasing weight of debt is a rising crisis for heavily leveraged (usually smaller) energy companies, and yes, debt is contributing to a rise in bankruptcies and mergers/acquisitions in the energy sector.
And that’s all the energy debt crisis is doing. There is no wider impact. Energy credit issues are not the reason broader markets are falling.
Some pundits think instead that it’s the wider effects of the price of oil that are the culprit…
3. Energy Investment Has Not Fallen Enough to Affect the Wider Economy
According to some, the markets falling alongside oil is a matter of general investment pressure. The reasoning here is that oil capital expenditures comprise a primary source of investment into the economy as a whole.
As the price of oil has fallen, oil companies have been slashing their capital expenditure budgets, thus depriving the wider economy of investment.
Depending on which figures you accept, oil companies can account for up to a third of capital expenditure among S&P 500 companies, while the oil industry workforce accounts for just a fraction of the national total.
Now, there is some truth to this argument. Companies have cut forward and new project investments and that has translated into loss of jobs.
But that’s where the argument goes awry.
You see, oil companies continue to invest in existing fields and operations, along with select new projects (especially vertical, shallow drilling).
This is hardly an all or nothing situation. In fact, despite cuts to more expensive future projects, overall oil production is increasing as better technology and efficiency kick in.
Meanwhile, the job losses remain limited to particular regions and job classifications.
Most importantly, neither oil-related job losses nor investment cuts have crossed over to the economy as a whole – where both the investment and employment pictures have been improving.
Faced with these facts, pundits often retreat to one final “reason” why oil and stocks are linked…
4. Stocks Are Not Being Sold to Cover Losses in Energy
Having run out of other options, pundits will often appeal to some overall selling mentality. In short, due to the dive in oil prices global investors have been forced to sell other holdings to meet margins or other considerations.
Yet to the extent that this is happening at all, it is an indication of some rather narrow-sighted ideas of risk diversification. It is simply untrue that those investing heavily in crude are sacrificing other segments of the market.
Once again, there is no basis for such a cross-over.
In sum, there are a number of reasons why the stock market is moving down. Oil is only one of them, and hardly the main one.
As for what’s keeping oil down, that is quite different…
Manufactured Panics Are Driving Down Oil and Markets Both
The primary reason for the current dip in oil prices remains the global surplus in crude supply. This is partly due to simple supply and demand dynamics.
But the depth of this decline is a result of actions by certain funds and traders.
There is now a heavy short move on crude, augmented by the usage of exotic derivative papers in the futures contract market, along with large institutionalized “flash” and computerized trading.
It is here that I have to warn you about how certain pundits advance their own profits at the markets’ expense…
And at yours.
Suppose “Chicken Little” from “The Sky is Falling Hedge Fund” comes on screen and talks about oil moving down to $18 a barrel (or even lower). While doing so, he shows some moderated “panic.”
Of course, the hedge fund is already running short positions on crude that will profit if anybody watching the interview buys the “panic.”
As I have discussed before here in Oil & Energy Investor, I’ve set up an algorithm to track these artificial oil price machinations. That algorithm is now saying that the premium for these moves now averages $12 a barrel.
In other words, oil quoted at $30 has an actual market value of about $42.
To make this “panic” really stick, of course, this “Chicken Little” has to talk about more than just oil. The more fear he can drum up about China’s slowing growth, the U.S. economy, and so on, the better for him.
So much the worse for the stock market, which (just like the price of oil) ends up going down as investors retreat.
There are two main takeaways from this. First, don’t buy the “panics” pundits try to sell you on TV.
Second, we do not need a major upswing in prices to disconnect oil from the larger market. A stable price in the low $40s is enough. That’s when selling panics no longer works, and oil and stocks begin marching to their own drummers.
At that point, we are also likely to witness the more traditional result of low oil prices – other sectors of the market (and of the energy sector itself) benefitting from a low price for crude oil.
And Chicken Little will have to go and play in some other barnyard.
P.S. I recently discussed exactly what needs to happen to get oil back up to the low $40s here in Oil & Energy Investor. If you missed it, just click here.