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August 22, 2004
How
Oil Affects the Stock Market
by John Brasher, CallWriter Publisher
| Several
of our members have written recently to ask for an article
discussing how crude oil prices affect the stock market. We
actually do listen to our members, and this is as good a time
as any to cover this subject. The basic rule is: oil up, stocks
down, and vice versa. This isn't hoary old trading lore, either,
but verified by modern studies that we'll discuss below. And
the prognosis for the short and intermediate term is not good.
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The crude oil market is the largest
commodity market in the world. Total world consumption equals around
70-80 million barrels a day of which the United States consumes
approximately 25 percent. That's right: we burn one out of four
barrels produced, even though we have less than 5% of the world's
population. Several times total consumption is traded daily on crude
oil, spot, futures and over-the-counter markets at exchanges in
New York (NYMEX) and London (IPE).
As most of you know, the price of crude
oil soared on Wednesday, August 18th to over $49 a barrel. This
is trumpeted as the highest oil price ever, but even a moment's
reflection shows this is not true. Oil prices soared to $35 and
over several times back in the 1980s, when the dollar was worth
a whole lot more than it is today. So the truth is that in terms
of adjusted dollars, oil has been much higher.
However, oil prices exerted a terrible
influence on the stock market in the 1970s and 1980s and are now
doing so again. Crude prices could spike even higher, but may well
pull back in the short term (the next few weeks). Some have speculated
that crude oil prices could hit $100/barrel in one to two years
if events fall into place just right (or
from our perspective, just wrong).
A couple of factors are driving oil
prices, and they aren't going away any time soon. The first
is the continuing increase in worldwide demand for oil. America
is the world's number one oil hog, but many countries are scrambling
to catch up. China, Vietnam and many other Third World countries,
particularly in Asia, are rapidly industrializing and their citizens
are buying cars in ever-increasing numbers.
This is no place for a "green" lecture
and I'm not in the mood for one, anyway, but the failure to develop
alternative energy sources is leading us and the rest of the world
to a crunch of enormous proportions. There is an end to petroleum
- neither you nor I know exactly where it will come, but it is coming.
Only the dizziest optimists believe that oil supplies are never-ending.
Experts are increasingly predicting a crash in the world economy
by 2025 as our oil dependence increases and oil supplies continue
to shrink. In the next few years, alternative-energy companies (solar,
hydrogen fuel cell and many others) will become some of the hottest
public companies.
The other force driving prices
is organized terrorism in the Middle East. Destroying oil production
in Iraq and other producer countries, which will drive up crude
prices, is seen by terrorists as a highly desirable goal. Recently,
Shiite militants attacked an oil facility in Basra, Iraq, and destroyed
offices and other facilities. And they aren't even the real terrorists!
The fear of terrorism's effects on oil prices probably will be worse
than the effects themselves are, but these fears are in part driving
crude prices.
Political unrest in Venezuela, the number
5 oil-producing country, contributed to concerns about oil earlier
this year. Whether you are personally nervous about al-Qaeda and
terrorism, accept the fact that the world markets are very jittery.
Interestingly, many traders believe that oil future prices would
drop significantly if bin Laden were caught, even if only temporarily.
While some want to believe that oil
concerns will ease medium term and that crude prices will fall below
$20 again, don't count on it.
Oil is used for so many things, I couldn't
even list them all in this article. From petroleum we primarily
make gasoline and diesel fuels, heating oil, fuel oil that is burned
to generate electricity for a large part of Earth's population,
greases and lubricants, and of course, plastics of all kinds. And
this list is just the tip of the iceberg, although they account
for the majority of petroleum used. Now of all these uses, ask yourself
which ones are seeing a decline in demand or production. The answer
is NONE.
Demand is increasing for everything
I can think of that we make from petroleum. Naturally, increases
in petroleum prices have an effect on the economy, and thus indirectly
on consumers, but increases also affect consumers directly.
When prices go up, prices at the pump
soon follow, sometimes almost immediately. Let's say you are an
oil refiner and you have stocks of $30/barrel oil on hand. Then
oil starts moving up and the price increases to $40. You don't sharply
raise prices instantly, but the oil you buy to replace stocks as
they are used up will cost you more. So you increase the wholesale
prices to distributors, which quickly translates to higher prices
at the pump. You buy oil futures to hedge against price increases,
of course. Petroleum industry players are always buying and selling
crude oil futures. Most traders buy and sell oil contracts like
any other security.
But if you are a refiner or in any business
where you need the oil, you are looking for actual delivery of the
oil. So the refiner is always using oil futures to hedge. But hedging
does a limited amount of good where prices go up and stay up. Put
differently, when oil prices went to $40/bbl. you weren't paying
that much because you had already bought oil futures as $33, $35
and so on. But at some point the cheaper futures contracts expire,
and you do pay $40 and then more than $40. As your cost of crude
goes up, you keep raising wholesale prices of the petroleum products
you make, and each increase raises prices at the gas pump.
Gas prices are high because oil prices are high. And prices at the
pump go up when oil goes up, a lot faster than pump prices come
down when crude goes down.
Higher prices at the pump hurt individuals
(and SUV sales) directly, since more money out of the budget for
gasoline means less money to spend on burgers, WalMart and so on.
But the indirect effect on consumers is also pronounced. Businesses
pay higher prices for gas products, also. Prices in stores increase
as it costs more to ship the goods. It is a spiral, and everyone
in the chain of production and the chain of retail sales increases
prices. Shippers and airlines typically pass energy-price increases
on to consumers in the form of fuel surcharges.
If oil prices continue upward and remain
high for a long period, energy-dependent businesses inevitably will
suffer. Transportation (trucking, airlines, overnight couriers,
etc.) is the most vulnerable, and auto companies can expect a drop
in sales of gas guzzling models. Money spent by consumers on oil is not spent
on other goods and services, obviously. That squeezes profits and
sales on a host of businesses.
Higher oil prices essentially act as a tax, slowing
economic growth.
As mentioned earlier, the general rule has been
that increased oil prices drive the stock markets down. This is
the conventional wisdom. But is it true? (Yes...) I want to point
out a very interesting paper entitled Striking Oil: Another
Puzzle, issued in November of 2003 by the Rotterdam School
of Economics. The authors point out that, prior to the 1970s oil
prices remained stable throughout most of the twentieth century,
due to a combination of production and price controls by the "Seven
Sisters," which were the largest oil companies in the world.
This price control came unglued by the Yom Kippur
War in 1973, when control of world petroleum production and prices
shifted to OPEC. At that point, oil prices began behaving like the
prices of other commodities. The following graph of petroleum prices
says it all. Shown are West Texas Intermediate Oil Prices from 1947
to 2003, in US dollars per barrel.
Source: Global Financial Data Inc.
Look at that chart move around after 1973. It's
like what happened after the preacher's kid was let loose in Sinville.
But remember, oil is not just any commodity. It is THE commodity.
The Striking Oil paper set out to
address the question whether oil prices might forecast future stock
market returns. Basing their conclusions on stock market data of
48 countries, a world market index and price series of several types
of oil, the authors concluded that oil prices do indeed forecast
stock market returns, stating that, "We
find that changes in oil prices strongly predict future stock market
returns in many countries in the world... The impact of this predictability
on stock returns tends to be large."
The authors also noted that "Stock
returns tend to be lower after oil price increases and higher if
the oil price falls in the previous month." For the developed
markets the study found that the change in oil price significantly
predicts future market returns in 12 of the 18 developed markets.
In all countries the effect is negative. That is, a decrease in
this month’s oil price on average indicates a higher stock market
return next month.
The impact of changes in the oil price on stock
returns tends to be large. For instance, a decrease of the oil price
of 10% in the U.S. will double the expected return
on the stock market in the following month. This oil effect is also
significantly present in the world market index.
In other words, the stock market tends to move
in the opposite direction to oil prices. Oil up, stocks down.
Oil down, stocks up. This is a one-way street, however; stock market
returns do not drive crude oil prices. So you can expect oil to
be the primary force driving the stock markets until further notice.
But the effects of oil prices are more subtle than
that. All sectors are not affected equally, or at the same time.
Here is what the authors found as to U.S. sectors when oil prices
rise:
- Most negatively
influenced: Cyclical Services.
- Next most
negatively influenced: Cyclical Consumer Goods.
- Third most
negatively influenced: Financials.
Cyclical
Services includes general retailers, support services, leisure
and hotels, entertainment and media, and transport. Cyclical
Consumer Goods include household goods and textiles, automobiles
and parts. Financials are investment companies, banks,
specialty and other finance, life assurance, insurance, real estate.
Consumer discretionary spending takes a hit quickly
as oil prices translate to higher pump prices (and higher prices for fuel oil, etc.).
Correspondingly, notice how general retail, leisure and hotels,
travel and entertainment are the first hit by higher oil prices.
Today American consumers are carrying record levels of debt, while
savings levels are low. Incomes are being eroded year by year, which
higher oil prices only exacerbate, so consumers are highly vulnerable
to higher oil prices. Like I said,, it's essentially another tax.
Now let's factor in current market valuations.
Over the decades, the long-term historical average of the Standard
& Poors P/E (stock price to earnings) ratio has been approximately
15, meaning that stocks over time have on average traded
at 15 times earnings. The current P/E ratio based on trailing earnings
is 30. So compared to historical averages, the market is
highly overvalued.
Before you pooh-pooh this notion as more sky-is-falling
hand wringing, remember that in late 1999 and early 2000, many market
mavens were ridiculing warnings that the market was overvalued.
What is value, really, they asked. A couple even suggested that
P/E valuations were historical artifacts and no longer very relevant.
Then the bubble popped.
Why is the market overvalued? Valuation is not
an abstractionl it is a pretty concrete thing. The high valuations
tell us not that stock prices are too high, but that prices are
too high in light of corporate earnings. So we have an overvalued market (at least compared to the historical average),
a stuttering economy that continues to disappoint and very high
oil prices.
What could drive petroleum prices back down - and
stimulate the markets? Either an increase in production, or a drop
in demand. But demand is increasing, pardner, and fast. On the other
hand, OPEC is producing pretty much all it can, so there is no windfall
supply of oil to be expected that can drive down prices. I'm not
expecting crude to get much cheaper in the medium term.
Having said that, even a 10-15% decrease in oil
prices would stimulate the markets. Who knows? While other factors
influence the markets, oil prices are a major stimulant or retardant.
I would dearly love to tell you what oil prices,
and the stock market, will do over the next year. But my crystal
ball is no better than yours. The key is not figuring out where
the market is going, but to trade in light of the prevailing
trend. So let's put our heads together and figure out what
the trend is.
The market has since May 2004 been in a steady
downtrend, but a downtrend with a large rolling motion - a lot of
amplitude. On the Dow Jones Industrial Averages (INDU), price
has now fought its way back to the trend line. The following chart
illustrates my point:
Note the upper and lower trend lines bounding the
market's downtrend since May. The market found support
at Points A, B and C. By the same token, the
trend line acted as resistance at Points D, E,
F, G and H. At Point G the market tried hard for
most of June to break out of the downtrend into a trading range,
but lacked the energy and fell back to the trend line, then back
below it. Now the market is back testing the upper trendline at
Point I. Don't get too excited right this minute, since there
has only been one close above the trend line at Point I.
Will the market break through now and establish
a new trading pattern? By this, I mean will it break through the
upper trendline (breaking out of the
downtrend) into a ranging market? It's too early to tell,
but its action at Point G is instructive. Looking at a daily, weekly
or monthly chart, the trend is down. I think a ranging market is
the most we can hope for any time soon. And even that will require
a fair number of closes above the upper trend line, with strong
volume, which we haven't seen in a while.
None of the above observations about oil prices,
the economy or valuations provide any sunshine.
Does this mean you cannot write covered calls in
this market or trade this market? Of course not. You can successfully
write covered calls in all but strong downtrends. CallWriter teaches
this point as a core part of its trading strategy. Those of you
concerned about the market's direction and fearful of a large correction
should write all covered calls at the money (ATM)
or well in the money (ITM). Stick to larger, more
liquid stocks and get lots of protection when you write. If the
market is really dropping when you are considering a trade (as it did on the above chart from D to A or
F to C), either write deeply in the money or don't
write covered calls. Remember, you don't have to trade.
But remember also, that trend lines act as support
and resistance points! Our preference is to let the market find
support and write off the bounce. To illustrate bounce writing,
note how the market made strong moves up from Points B and
C! At those points you could have written almost any decent
stock out of the money and made money on the trade. I mentioned
amplitude above, which is the height
of each wave from trough to crest. On downtrends with large amplitude,
like the current market has, there are great opportunities to trade
the troughs and crests. Here's how:
Bounces: One you are satisfied the market has
indeed found support, write out-of-the-money
or at-the-money covered calls, write naked puts
or simply buy calls, depending on your taste and
your account approval level.
Pullbacks: Once satisfied that the market has
hit resistance and is pulling back, write naked
calls or buy puts. A pullback really is
not the place to write covered calls unless the price down leg
is gentle to moderate and you are writing deeply in the money.
In writing troughs or crests, however, you have
to be able to see the trend. For this reason, it would have been
much more comforting, and safer, to write off of the bounce at Point
C than Point B on the above INDU chart. (Why? Because Point C confirmed the trend that
A and B actually established.)
Traders
in the stock and option markets should not position themselves at
this point based on what oil may or may not do. Future oil price
moves and their effects on the market from month to month are unknown
and impossible to game. Instead, figure on this flaky market to
continue. But cheer up! As the above trading observations make clear,
there is always a way to make money. You just have
to trade in a way that takes advantage of the trend.
This article is over-simplified, for which I apologize.
There is no way to exhaustively cover the topic of the "oil effect"
in this space, but those of you looking for the bigger picture hopefully
have a better feel now for how oil prices, the economy and the stock
market work together. Keep in mind, though, that oil prices are
just one input to the markets. Other factors can cause markets to
move up or down.
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