What Oil Prices Mean for the Stock Market

Oil prices have been highly volatile over the past few months, wreaking havoc not just on energy stocks, but on equities in general. Why does oil have this seemingly all-important focus and what does it mean for the stock market? In truth there are multiple implications that oil prices have on the market and economy. Likewise, there are an equally large number of inputs that effect the commodity’s price.

Generally speaking, stock investors follow just a few commodities, mainly oil and gold. Others investors may follow natural gas, silver, copper and a few other commodities, but without question, gold and oil are the two most popular. The latter is arguably the most important though, because of its implications on the economy.

With the energy sector making up less than 10% of the S&P 500, oil prices have a limited but evident impact on the market’s most notable index. When oil prices are on the rise, energy stocks generally are as well. All things equal, that’s good for stocks. Obviously the flip side of that is bad news for the S&P 500.

But what dynamics are we really working with?

Oil’s Impact on the Economy

Are rising oil prices a net negative or net positive for the economy? On the surface, the answer is easy: Of course rising oil prices are bad for the economy. It leads to higher gas prices for consumers, higher fuel costs for airlines and cruise operators, and higher transportation costs for logistics operators.

Despite all that, many view rising oil prices as a good thing for the economy. 

Here’s why.

On one hand, rising oil prices will draw in more production from the energy sector. That’s more jobs in the fields extracting crude oil from the earth, more jobs on the pipelines and railroads to transport it and more jobs at the refineries.

Far more important though, many investors use rising oil prices to indicate one thing: rising demand.

At the end of the day, oil prices come down to the simple economic principle of supply and demand. Simply put, when the economy is strong, demand is too and the higher oil prices go. As the economy flounders, demand for oil falls and the lower prices go. That’s precisely the reason why so many investors view rising oil prices as a good thing for the economy. To them, it means that the global economy is gaining steam and therefore more oil is needed. As a result, when oil prices rise, so too do stock prices. Never mind the fact that it’s an overall negative for consumers, airlines, cruise operators, truckers and others.

Oil’s Own Factors Are Growing

If the only consideration came from the demand side, this game would be easy. As laid out above, rising demand means economic activity is increasing. Therefore oil prices — and thus stock prices — rise in unison. The opposite is also true. Lately, that seems to be a tight correlation. But it can change at any time and one reason why is supply.

Put simply, the United States has become a huge player in the oil market. When prices collapsed a few years ago, it forced many of these companies — whether in the Permian basin or otherwise — to become lean and mean. This meant reducing production costs as low as they could, driving break-even costs down to levels many thought were impossible. 

Because a company like Exxon or BP can turn on the spigot — literally — when prices start to creep higher, they essentially have a cash cow just waiting to produce. Too much supply and energy companies will sink oil prices to unprofitable levels. But the point is all the same: By keeping the supply side flush, it keeps a lid on oil prices, making the economic theory harder to interpret.

The complexity only grows when we take foreign production into consideration.

Oil prices

One-year daily chart of oil prices

The Bottom Line on Oil Prices

So where the heck does that leave us — is oil really an indicator of economic health or not? Is rising oil prices good or bad for the economy?

The answer is, unfortunately, a mixed bag. Oil prices are an economic indicator when demand is driving it and supply is being kept in check. Meaning that, supply isn’t gushing into the market nor is it so short that the market is having a price squeeze. Ultimately though, supply does play a role in oil prices and with the additional output in the United States, it’s playing an even larger role.

That may leave some scratching their heads as to how oil prices are a helpful indicator then. Well, know this. If oil prices — which just enjoyed one of their largest monthly gains ever in January, up 18% — press higher, demand isn’t lacking. In which case, we can take away a positive interpretation for the global economy. While rising oil prices will hurt retail and consumers, there’s flexibility to a point. Even as gas prices trend higher, it won’t break the consumer overnight.

All that said, it doesn’t take a rocket scientist to connect the dots. Look at the chart above. Oil prices topped out right at the start of the fourth quarter — just like the S&P 500. And surprise, surprise, when did it bottom? Right near Christmas Eve, just as the market did as well. If anything, keep oil prices on your radar.