The start of 2016 was one to forget for many stock market investors, as a plunge in the price of oil created a visual bloodbath on stock boards, with virtually every number turning red.
On the face of it, that reaction to a dramatic drop in the price of oil should have created the opposite response, as cheap prices for gasoline and other fuels is normally good news for consumers and industrial companies.
As the folks at Money Morning will confirm, oil prices are inextricably linked with the stock market and that has been the case for a very long time, but it is not always apparent why this is the case.
In order to understand the correlation between the stock market and oil prices you probably need to break down the relationship into various different components.
Changes in energy costs can certainly influence stock market prices and those energy costs are of course heavily related to where the oil price is headed.
The effect of energy costs rising or falling don’t just change productions costs and the price that motorists are paying at the gas station, as the economy is made up of plenty of other parts such as wages, interest rate levels, and the price of raw materials, all of which can offset changes in energy costs.
Oil prices are largely determined by the supply and demand for products that are based around the use of petroleum-based products, so it is reasonable to assume that prices might rise when consumption levels increase or they could fall due to increased production.
There is an argument to suggest that stock prices in certain sector could be more entwined with oil prices than others, and transportation is probably the prime example of this.
It is fairly logical that the transportation sector of the stock market is strongly linked to the spot price of oil, mainly due to the fact that fuel costs are one of the major overheads that influence their ability to make a profit on their transport services.
There are a number of investors who take the view that it pays to short certain stocks in the transportation sector when oil prices are high and take the opposite approach when oil prices are heading south.
Oil companies are hurting
As a result of steady decline in the price of oil, there are a number of blue chips who are suffering from falling profit margins and a sharp decline in their share price too.
Demand for oil has risen but there is a glut of oil being stockpiled, which means that more oil is continuously flowing into a market that is already virtually drowning in an oversupply of crude. The International Energy Agency has predicted that the first half of 2016 will see global oil supply outstrip demand by some 1.5 million barrels per day, so it would be hard to have confidence at the moment that supply and demand factors will help to drive up the oil price while this situation continues.
Stock market hurts too
The fact that so many multinational oil company’s shares are held in many institutional investors portfolio’s, such as major pension funds, means that low oil prices can hurt the markets in general.
The question is why do low oil prices have the capacity to hurt the stock market?
You can put forward several educated answers to this question, but in simplistic terms, oil company profits are falling, which causes oil company shares in general to fall, which in turn, tends to impact on the market as a whole.
The reason for this knock-on effect goes back to the observation that so many of the big oil company share are held in large pension portfolios and by a large number of private investors, that concerns over their profits and ability to maintain their attractive dividend, will create nervousness and drive prices down overall.
If you look at the performance of the S&P 500 for 2015, it gives you a fair indication of the heavy influence that oil companies and the price of crude oil can have on markets in general.
The S&P 500 dropped 5.8% in 2015, but even in those recession-like conditions we saw during the year, if you removed all the energy companies from that calculation, the S&P would have returned a profit of 5.7%. Providing a clear indication that lower share prices for oil companies have the capacity to drag down entire indexes.
Whichever way you look at, oil prices and the stock market are “in a relationship”.
Emma Miah writes about the stock market for a selection of investment and finance blogs. With a background in finance, and personally interested in the stock market, she writes on the subject in her free time.