About four months ago, it became clear that very low oil prices and much cheaper gasoline were not a good thing for the stock market. Now, the world’s largest commodity and the global indexes are trading in a near lock-step with correlations over 90%. This is close to cats and dogs living together—until you look at it a little closer; then it only seems slightly bizarre.

[pullquote align=”full” cite=”” link=”” color=”” class=”” size=””]The most important concept is that of oil as collateral. Borrowing (and lending) for energy has exploded in the last couple decades[/pullquote]

For most individuals and many economists, a higher oil price appears as a tax on the consumer because transportation, heating and energy-sensitive food costs represent a meaningful part of the monthly budget. When oil prices fall, it typically increases discretionary income because expenses are lower. And that’s usually a good thing if people spend the savings. Some claim that consumers are not spending the incremental savings, but I think this discussion misses the point.

There are two ways to view this stock/oil conundrum that help to see it as somewhat more rational (it still seems eerie and foreboding to me).

Oil as Income, Wealth and Collateral

First, it helps to think of oil as income, wealth, and collateral rather than a factor of production and an expense.

Much of the developing (and some of the developed) world relies on oil and related energy revenues for income. Imagine that your paycheck were tied to the price of oil: what would your life be like if household income dropped 70-80% in the last 18 months? Certainly, as yours would have been, budgets have been cut in Saudi Arabia and Russia, to name only two countries whose fortunes have been deeply affected by lost energy revenues.

Another speculation is that countries who built up asset portfolios with excess “petro dollars” are now selling some of those assets—often stocks and bonds–to fund the deficits. The theory is that with each drop in oil prices, the threat of more liquation weighs on stocks.

The most important concept is that of oil as collateral. Borrowing (and lending) for energy has exploded in the last couple decades., and the estimates I see for energy industry debt levels are typically in the five hundred-billion range. That’s a big enough number to cause real turmoil, but it’s hard to see the indirect debt that is affected for related industries, suppliers, and substitute products. The effect of the sudden loss of collateral for the lenders is already showing up as source of fear for the credit markets. Credit spreads (the differences between safe and risky debt) are widening in another highly correlated move with oil prices.

Oil as Canary in the Coal Mine

The second way to view the role of oil is to see it as an indicator of economic activity. Because oil is highly leveraged in financial markets, it is very sensitive to changes in demand. Like the fated canary whose high respiration rate made it more sensitive to gas in the mines of old, falling oil prices presage a slowing global economy—one usually attributed to the slowdown in China. Related commodities partly confirm the oil drop as a sign that global growth is slowing. Most commodity indices are down about 50% in the last 18 months.

The combination of these views makes it easier to see correlation as plausible, but can the lockstep in oil and stock trading continue? It’s hard to see how. The latest correlation has been roughly five-to-one (oil-to-SP500) on a percentage basis. This implies that if oil rose by 20% (6$/bbl), that should give the SP500 index an upward move of 4% or so. That would put the index up 2% for the year—this after a robust 7% move off the lows in late February already. Really? Oil would only be about 38.50 per barrel and that’s still a painful level for many producers. And the earnings and economic news lately has not been encouraging—at least not enough to justify prices near their highs.

When will this change? –When other factors that play into stock prices cause the programs that feed off of and drive this correlation to be abandoned. This could require changes in earnings, in credit downgrades, or changes in any of the economic forecasts that drive stocks before they can be driven by oil.

Meanwhile, the next time someone asks you what you thing the market will do, rephrase the question for them: “You mean what will oil do?”

WH