How does oil impact global capital markets?
Oil is one of the most traded assets worldwide, but how does it correlate with equities and what impact its price fluctuations might have on national economies and capital markets?
To begin with, oil is probably the most important asset on the planet, even though not many traders realise this. It has played a crucial role in the industrialization of most developed and emerging economies since it’s the lifeblood of any economy. It has shaped the geopolitical landscapes for decades. In fact, the US dollar is now the world reserve currency thanks to oil, or Saudi Arabia to be more accurate.
When the greenback was chosen as the world reserve currency at Bretton Woods in 1944, it was pegged to gold with a ratio of $35 per ounce. When Nixon annulled these terms in 1971 given that the Fed had printed too many banknotes to be backed by the US gold reserves (see the Nixon shock), the US managed to convince Saudi Arabia and eventually other oil-producing countries to sell crude exclusively in exchange for USD, thus shifting the currency’s peg from gold to oil and saving it from imminent hyperinflation. That’s how the so-called petrodollar system was born. While it’s not my intention to condemn any entity, whenever a major oil-producing country tried to move from the US dollar and sell its oil for other currencies, it ended badly.
Nevertheless, things are changing, and the financial system has become more sophisticated and diverse since the 90s. Still, oil plays a key role, and its price fluctuations may impact various markets and assets
Oil price and correlation to Forex Pairs
Given that oil is quoted in US dollars, every time it fluctuates, many forex currencies tend to realign with the greenback. This correlation is more visible in nations that have oil reserves, including Canada, Russia, Norway or Brazil. Elsewhere, the national currencies of countries that don’t export oil, such as Japan, show less correlation to oil price fluctuations.
As of 2018, the countries with biggest oil export volumes were Saudi Arabia (over 10 million barrels per day (bpd), Russia (over 5 million bpd), Iraq (almost 4 million bpd), the US and Canada (over 3.6 million bpd), and the UAE and Kuwait (about 2 million bpd). Saudi Arabia, the UAE and Kuwait have pegged their currencies to the USD, so they show no volatility whatsoever in pair with the world’s reserve currency. As for the Russian ruble (RUB) and Canadian dollar (CAD), they react promptly every time oil experiences a sharp movement.
Even though the energy sector accounts for a considerable share of the US gross domestic product (GDP), the American economy is well diversified and doesn’t shake every time oil prices crash.
When it comes to oil-dependent currencies, they react instantly. For example, when crude futures collapsed in March-April to an unprecedented level of below zero, the USD/RUB pair surged from 65 at the beginning of March to over 80 on March 18. On a side note, oil prices crashed as many countries introduced strict lockdowns to curb the spread of the new coronavirus, thus damaging demand for oil.
Oil and Equities
Investors used to visualize a negative correlation between crude prices and the US stock market. The rationale behind this belief is that an increase in oil prices would lead to higher input costs for most companies and force end consumers to spend more money on gasoline, thus negatively affecting the business earnings. The opposite is said to happen when oil prices decline, as it leads to higher consumption and more affordable cost of production.
However, Andrea Pescatori, an economist at the International Monetary Fund (IMF), discovered that there was actually little correlation between oil and US indexes. In 2008, he tested the theory by monitoring changes in the benchmark S&P 500 index and oil prices. He found out that his variables moved in tandem only occasionally, though even then the relationship was not worthy of attention. His investigation concluded that no correlation exists between the two with a confidence level of 95%.
We may argue that this inverse relationship can be visible in the long-term. WTI futures dropped from over $100 in 2013 to less than $30 at the beginning of 2017. Meanwhile, the US stock market continued to rally during this period. Still, there are some instances on large timeframes when the two show positive correlation. The same correlation might occur when both markets react to the same major fundamentals, such as the pandemic and the lockdown measures. For example, in March-April, oil futures collapsed to the lowest level in 30 years and even showed negative prices, while the US equities showed the largest decline in decades and fell to multi-year lows.
Naturally, oil prices directly affect the energy and transportation sectors, so you might be interested in monitoring companies involved in oil-producing and trade, transportation, logistics whenever crude price increase in volatility. Also, crude has a direct impact on the stock market indexes of oil-dependent economies.
While it may be difficult to admit a positive or negative correlation between oil prices and Equity Markets, the two might often react to the same fundamentals. You can’t deny that higher oil prices increase the cost of doing business, but the US and Australian markets are well diversified to offset that effect.
