Market commentary: The relationship between oil and equities

The commodities market has been making the headlines for all the wrong reasons over the past months. General prices for commodities have fallen sharply as a result of reduced current and future expected economic growth. Arguably the most highly tracked commodity, oil, has been one of the worst hit amongst its commodity peers as the fuel has also been negatively impacted by supply side macroeconomic events.

The bear market for oil started back in September 2014, when oil was trading at around $100/barrel. Following a string of negative events including the stagnant global economic back-drop, the slowdown in China, the pledge by Saudi Arabia to eliminate US shale companies, the stronger dollar, the increasing output from OPEC countries and recently the entry of Iran into the industry after their sanctions were lifted have cumulatively resulted in a decline to a low of $26.21 in February 2016.

Since then the market has rebounded in line with most analysts short term expected levels of $30-40. Various analysts at this point expect oil to remain trading in this range in the short term until significant demand or supply side catalysts to different market conditions take place.

A topical discussion at the moment is the high positive correlation between the movements in prices of equities and the price of oil. The correlation between the two was particularly strong in the beginning of the year, with both markets essentially moving in line with each other, however the rate of acceleration in the price of equities has been greater recently.  At a point, the spatial awareness about the price of oil seemed to be the driving force in the markets. This begs the question, does the price of oil have a direct impact on the price of equities?

Oil affects the factors of production of companies, typically resulting in lower operating costs which should be positive for company margins. A lower oil price also typically results in higher disposable income to spend on other products and services, as fixed household costs such as electricity and fuelling your car is cheaper. Under this logical reasoning, the price of oil and equities should move in the opposite directions, so why don’t they?

If the decline in the price of oil were purely a supply side factor, this might probably hold true (except for oil related companies) if the oil revenues were not an integral part of countries budgets. Irrespective of whether it is a demand or supply factor, lower prices of oil for countries such as Russia, Venezuela and the Arab states significantly impacts the budget of these large economies which results in either budget cuts or significant indebtedness. Supply side factors, therefore have an indirect effect on demand in different areas of global economy.

Prices of financial assets fluctuate on the back of future expected growth rates, therefore demand declines from lower expected global growth will affect the price of oil negatively. These are the same factors that affect prices of equities, hence the positive correlation.

In conclusion, the answer to the question whether fluctuations in oil prices affect equities, is that it is more likely that they are both affected by the same macro-economic factors in the same way, as opposed to directly impacting each other in a significant way.

This article was issued by Simon Psaila, Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt .Theinformation, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.