Apr 22, 2016

Crude oil prices and equities have moved in lockstep thus far in 2016, signalling a rare correlation in which the price of oil appears to be driving the stock market. Since December 2015, the S&P 500 and oil prices have finished the day moving in the same direction on 44 out of the first 60 trading days. Oil futures reached a 12 year low at the beginning of 2016, a fall that was echoed in the US equities market which endured its worst ever start to a calendar year. While the causes of the current oil crisis have been widely documented, the rationale behind why this decline has been mirrored in the equities market seems slightly more indistinct. So what circumstances are driving this correlation and is it safe for the market to treat the relationship as a new norm?

While there is no hard and fast reason for this correlation, there appears to be a combination of possible contributing factors:

  1. Lack of confidence– the equity market is a highly unpredictable environment in which sentiment plays a major role, and the impact of oil plunging from above $100 to below $30 a barrel on market confidence should not be underestimated. Typically, falling oil prices are considered indicative of declining demand for oil, which itself is often treated as a symptom of global growth stagnation. Yet, despite the widespread perception that demand for oil is falling, it is actually still increasing. However, this growth in demand has been offset by a large increase in supply, driven by OPEC (the Organization of the Petroleum Exporting Countries) and the recent re-entry of Iran onto the global oil market. Subsequently, the supply of oil is considerably outstripping demand. Have investors mistakenly linked the tumbling price of oil with a decrease in demand? It may be that this ‘noise’ spilled over into equities, creating the bearish market of early 2016 and contributing to a somewhat unwarranted correlation between equities and the price of oil.
  1. Banks’ Exposure- one of the predominant reasons why oil prices and equities are closely linked is due to the large exposure (1%-6%) that the big banks have to energy companies. Due to the capital-intensive nature of oil production the industry is slow to react to price changes. Subsequently, oil companies are having trouble rolling over their debts as the majority of their previous capital lending was based on oil being priced at $100+ a barrel. Consequently, as the price of oil plummeted their liquidity decreased, causing their debts to become unaffordable. This has led to an increase in the number of energy companies becoming insolvent, while others are defaulting on their bond payments due to the lack of capital available to service those debts. This has resulted in a spill over where high yield debt outside of the energy sector has become harder to issue, with banks becoming more cautious of their overall exposure. This has a direct link with the equities market as firms will find it increasingly difficult to issue bonds and obtain credit, resulting in lower growth throughout the market.
  1. Equity Sell-off by Sovereign Wealth Funds-a Sovereign Wealth Fund (SWF) is a state-owned investment fund that is commonly established from balance of payments surpluses, FX operations, fiscal surpluses and resource exports. Many SWFs were created by oil-rich nations as ‘rainy day funds’ in order to invest and save the excess revenue generated from natural resource exports. When oil prices fell the cash flow of these nations started to dry up; this led to countries liquidising large parts of their SWFs in an attempt to bridge their liquidity gaps. When these funds are liquidated in great quantity there is often a large impact on the wider equity markets as demand falls and the value of stocks decline.

Is this relationship a new norm?

For the time being, the market appears to be stuck in a position where oil prices, rather than fundamentals, are driving sentiment within the equities market. In order for equities to break free from the current correlation, oil prices must become less volatile. Once stabilisation occurs, investor confidence in the wider global economy should follow, leading to fundamentals once again prevailing in driving the equities market. Oil futures rallied in March as it was expected that OPEC and the other major oil-exporting nations were to announce a production freeze. However, turbulence re-entered the market as Saudi Arabia announced they would only agree to a freeze if Iran were to follow suit. One must expect that equities and oil prices will continue in lockstep in the immediate future and as long as uncertainty is present within the oil market. However, given that this volatility is based on a series of abnormal events, it would be unwise for market participants to treat the correlation as an ongoing norm on which to base decisions.