One of the most fascinating things about global financial markets is the interaction between them. My background in foreign exchange gave me an inherent awareness of this. In that market it is impossible for any currency to fall without another rising, at least in relation to the first. This fact has a dampening effect on booms and busts. As any single country’s economy grows, so their currency becomes more desirable and strengthens, making their exports relatively expensive and therefore putting a natural break on that growth. This interaction is why free markets work; it is Adam Smith’s “invisible hand” from a global perspective.
There is a similar relationship between the US stock market and the price of oil. The United States is still the world’s largest consumer of oil, despite recent moves toward alternative energy sources, and its price affects every part of the economy. Thus, as the economy has improved after the recession, so the price of oil has recovered. As economic activity increases, so does the price of oil… up to a point. When that point is reached the increased cost of producing and transporting goods due to higher oil prices puts a damper on growth for a while. The economic growth falters, and so the price of oil drops, allowing growth to resume. This tends to stay in balance over time as long as demand is the main driver for the price. The problem comes when supply issues take center stage in the oil markets and a threat of disruption causes a spike in prices. This can dampen consumer spending and confidence as gas prices rise and put enormous cost pressure on businesses.
The problems in Egypt, given that country’s strategic importance to the supply of oil from the Middle East, have created that scenario and caused oil prices to rise over the last couple of days, pushing NYMEX crude above the psychologically important $100/BBL level.
The obvious question, then, is “should we be panicking?” The answer, in my opinion, is not yet. If we look at a longer term chart for oil prices and their correlation with the S&P 500, the picture becomes somewhat clearer.
As you can see, the oil price and the S&P 500 had been quite closely correlated from 2008 until about a year ago. At that point, oil prices began to fall as the stock market continued to rise, so some degree of coming together is only to be expected. One can also see from this chart that the aforementioned tipping point, where higher oil prices lead to a drop in the market, has been somewhere over $105/BBL in both of the last two years’ “summer swoons”. I would conclude, therefore, that $105 is a more important level for oil, in terms of impact on the stock market, than $100, and, given where the S&P is now, that tipping point may even be a little higher now than before.
In addition, it should be born in mind that Egypt is not a significant producer of oil itself. Concerns center on the country’s control of the Suez Canal and pipeline, through which around 4 million barrels of oil move every day. The unrest is worrying, but whatever regime gains control ensuring the continued flow of oil is likely to be a top priority, given the potential reaction of the world’s major powers should that flow be interrupted.
With this spike in prices coming right at a US holiday an overreaction in thin markets today and Friday wouldn’t surprise me, but this could really just set up some good long term buying opportunities for those who are paying attention. If oil prices continue to rise to above $110 or so, then I might have to re-think my generally bullish outlook for stocks in the medium term. For now, however, a return to more correlation between oil and stocks is more likely to be just part of the natural ebb and flow of the markets and definitely not a cause for panic.